HiioiS 
.  W3 


• 


MATERIALS  FOR  THE  STUDY 
OF  BUSINESS 


RISK  AND  RISK-BEARING 


THE  UNIVERSITY  OF  CHICAGO  PRESS 
CHICAGO,  ILLINOIS 

THE  BAKER  &  TAYLOR  COMPANY 
NEW  YORK 

THE  MACMILLAN  COMPANY  OF  CANADA,  LIMITED 

TORONTO 

THE  CAMBRIDGE  UNIVERSITY  PRESS 
LONDON 

THE  MARUZEN-KABUSHIKI-KAISHA 
TOKYO,  OSAKA,  KYOTO,  FUKUOKA,  SENDAI 

THE  COMMERCIAL  PRESS,  LIMITED 
SHANGHAI 


Risk  and  Risk-Bearing 


BY 

CHARLES  0.  HARDY 

THE  INSTITUTE  OF  ECONOMICS 
WASHINGTON,  D.C. 


THE  UNIVERSITY  OF  CHICAGO  PRESS 
CHICAGO,  ILLINOIS 


Boston  CHVge 

Tower  ReL  Library 


Copyright  1923  By 
The  University  of  Chicago 


All  Rights  Reserved 


Published  May  1923 
Second  Impression  March  1924 
Third  Impression  October  1927 
Fourth  Impression  December  1929 


146641 


Composed  and  Printed  By 
The  University  of  Chicago  Press 
Chicago,  Illinois,  U.S.A. 


f 


EDITOR’S  PREFACE 

Collegiate  training  for  business  administration  is  now  so  widely 
attempted  that  the  time  has  arrived  when  experiments  should  be 
conducted  looking  toward  the  organization  of  the  business  curriculum 
into  a  coherent  whole.  Training  in  scattered  “business  subjects” 
was  defensible  enough  in  the  earlier  days  of  collegiate  business  training, 
but  such  a  method  cannot  be  permanent.  It  must  yield  to  a  more 
comprehensive  organization. 

There  can  be  no  doubt  that  many  experiments  will  be  conducted 
looking  toward  this  goal;  they  are,  indeed,  already  under  way.  This 
series,  “Materials  for  the  Study  of  Business,”  marks  one  stage  in  such 
an  experiment  in  the  School  of  Commerce  and  Administration  of  the 
University  of  Chicago. 

It  is  appropriate  that  the  hypotheses  on  which  this  experiment  is 
being  conducted  be  set  forth.  In  general  terms  the  reasoning  back 
of  the  experiment  runs  as  follows:  The  business  executive  administers 
his  business  under  conditions  imposed  by  his  environment,  both 
physical  and  social.  The  student  should  accordingly  have  an  under¬ 
standing  of  the  physical  environment.  This  justifies  attention  to 
the  earth  sciences.  He  should  also  have  an  understanding  of  the 
social  environment  and  must  accordingly  give  attention  to  civics,  law, 
economics,  social  psychology,  and  other  branches  of  the  social  sciences. 
His  knowledge  of  environment  should  not  be  too  abstract  in  character. 
It  should  be  given  practical  content,  and  should  be  closely  related  to 
his  knowledge  of  the  internal  problems  of  management.  This  may  be 
accomplished  through  a  range  of  courses  dealing  with  business  admin¬ 
istration  wherein  the  student  may  become  acquainted  with  such  mat¬ 
ters  as  the  measuring  aids  of  control,  the  communicating  aids  of 
control,  organization  policies  and  methods;  the  manager’s  relation 
to  production,  to  labor,  to  finance,  to  technology,  to  risk-bearing, 
to  the  market,  to  social  control,  etc.  Business  is,  after  all,  a  pecuni¬ 
arily  organized  scheme  of  gratifying  human  wants,  and,  properly 
understood,  falls  little  short  of  being  as  broad,  as  inclusive,  as  life 
itself  in  its  motives,  aspirations,  and  social  obligations.  It  falls 
little  short  of  being  as  broad  as  all  science  in  its  technique.  Training 


Vll 


Vlll 


EDITOR’S  PREFACE 


BASIC  ELEMENTS  OF  THE  BUSINESS  CURRICULUM 

Of  problems  of  adjustment  tc 
physical  environment 

a)  The  earth  sciences 

b)  The  manager’s  relationship 
to  these 


Control 

1.  Communicating  aids  of  control, 

for  example 

a)  English 

b)  Foreign  language 

2.  Measuring  aids  of  control,  for 

example 

a)  Mathematics 

b)  Statistics  and  accounting 

3.  Standards  and  practices  of  con¬ 

trol 

a )  Psychology 

b)  Organization  policies  and 
methods 


Of  problems  of  technology 

a)  Physics  through  mechanics, 
basic,  and  other  sciences 
as  appropriate 

b)  The  manager’s  administra¬ 
tion  ol  production 

Of  problems  of  finance 

a)  The  financial  organization 
of  society 

b)  The  manager’s  adminis¬ 
tration  of  finance 

Of  problems  connected  with  the 
market 

a)  Market  functions  and  mar¬ 
ket  structure 

b)  The  manager’s  administra¬ 
tion  of  marketing  (including 
purchasing  and  traffic) 

Of  problems  of  risk  and  risk¬ 
bearing 

a)  The  risk  aspects  of  modern 
industrial  society 

b)  The  manager’s  administra¬ 
tion  of  risk-bearing 

Of  problems  of  personnel 

a )  The  position  of  the  worker 
in  modern  industrial  society 

b)  The  manager’s  administra¬ 
tion  of  personnel 

Of  problems  of  adjustment  to 
social  environment 

a)  The  historical  background 

b)  The  socio-economic  insti¬ 
tutional  life 

c)  Business  law  and  govern¬ 
ment 


EDITOR’S  PREFACE 


IX 


for  the  task  of  the  business  administrator  must  have  breadth  and 
depth  comparable  with  those  of  the  task. 

Stating  the  matter  in  another  way,  the  modern  business  admin¬ 
istrator  is  essentially  a  solver  of  business  problems — problems  of  busi¬ 
ness  policy,  of  organization,  and  of  operation.  These  problems,  great 
in  number  and  broad  in  scope,  divide  themselves  into  certain  type 
groups,  and  in  each  type  group  there  are  certain  classes  of  obstacles 
to  be  overcome,  as  well  as  certain  aids,  or  materials  of  solution. 

If  these  problems  are  arranged  (i)  to  show  the  significance  of  the 
organizing  and  administrative,  or  control,  activities  of  the  modern 
responsible  manager,  and  (2)  to  indicate  appropriate  fields  of  train¬ 
ing,  the  diagram  on  the  opposite  page  (which  disregards  much  over¬ 
lapping  and  interacting)  results.  It  sets  forth  the  present  hypothesis 
of  the  School  of  Commerce  and  Administration  concerning  the  basic 
elements  of  the  business  curriculum,  covering  both  secondary  school 
and  collegiate  work. 

This  present  volume  deals  with  the  problems  of  risk  and  risk¬ 
bearing. 


L.  C.  Marshall 


.. 


* 


AUTHOR’S  PREFACE 


This  volume  grows  out  of  an  effort  on  the  part  of  the  Faculty  of 
the  School  of  Commerce  and  Administration  of  the  University  of  Chi¬ 
cago  to  reorganize  its  curriculum  so  as  to  make  its  courses  correspond 
to  the  functions  performed  in  the  process  of  providing  present-day 
civilized  society  with  economic  goods.  In  view  of  the  extent  to 
which  the  book  owes  its  existence  to  the  need  of  a  text  to  fill  a  gap 
in  the  equipment  available  for  carrying  out  such  a  plan,  this  may 
be  an  appropriate  place  to  indicate  something  of  the  nature  of  the 
instruction  scheme  in  which  a  course  in  risk  and  risk-bearing  finds  a 
place. 

In  his  Freshman  year,  a  student  regularly  takes  a  sequence  of 
courses  dealing  with  the  whole  field  of  economics  and  business  adminis¬ 
tration,  the  usual  sequence  being  Industrial  Society,  Value  and 
Distribution,  Business  Administration.  These  courses  are  designed 
to  give  him  a  view  of  the  whole  field  with  which  his  later  studies  have 
to  do,  largely  for  the  purpose  of  enabling  him  to  approach  the  more 
detailed  courses  with  a  better  grasp  of  the  relationship  between  the 
things  he  is  at  the  moment  studying  and  the  rest  of  the  economic 
order.  The  course  in  Industrial  Society,  in  particular,  concerns  itself 
with  the  interrelations  of  the  various  institutions  which  make  up  the 
economic  organization  of  society. 

There  follows  during  the  Sophomore  and  Junior  years  a  group  of 
intermediate  courses  which  together  cover  the  entire  field  in  more 
detail,  each  dealing  with  a  specific  social-economic  function,  the 
institutions  through  which  this  function  is  performed,  and  the  prob¬ 
lems  of  administration  which  arise  out  of  its  performance.  These 
functions  are  six:  production  (in  the  technological  sense),  finance, 
marketing,  labor,  risk-bearing,  and  social  control.  Courses  dealing 
with  these  functions,  together  with  another  group  which  deals  with 
the  recording,  facilitating,  communicating,  and  computing  aids  to 
business  administration1  make  up  the  backbone  of  the  curriculum, 
and  are  required  of  all  students,  whereas  advanced  courses  dealing 
with  specific  problems  in  these  fields  (such  as  investment  analysis, 

*  Including  accounting,  statistics,  business  communication. 


xi 


Xll 


AUTHOR’S  PREFACE 


foreign  trade,  bank  management,  trade  unions)  are  required  only 
of  students  specializing  in  the  given  field. 

Of  the  six  functions  referred  to,  risk-bearing  is  the  most  likely 
to  require  explanation.  As  will  be  seen  by  an  examination  of  the 
Table  of  Contents  of  this  volume,  the  course  out  of  which  it  has  grown 
is  made  up  of  material  much  of  which  ha?  traditionally  been  presented 
in  courses  in  the  theory  of  distribution,  money  and  banking,  insurance, 
investments,  marketing,  and  speculation.  To  some,  these  elements 
may  perhaps  seem  incongruous,  and  it  may  even  be  suspected  that  the 
principle  of  selection  has  been  that  of  lumping  together  various  odds 
and  ends  crowded  out  of  other  courses.  Such  a  procedure  might 
be  justifiable.  Indeed,  from  a  practical  point  of  view,  one  of  the 
direct  gains  from  the  organization  of  the  course  was  that  it  made 
possible  the  offering  of  what  seems  to  the  author  an  adequate  amount 
of  work  in  life  and  fire  insurance,  speculation,  and  business  forecasting 
to  meet  the  needs  of  the  majority  of  students,  without  the  necessity 
of  injecting  into  each  subject  for  administrative  reasons  a  sufficient 
amount  of  material  to  fill  out  a  conventional  number  of  “student 
hours”  to  constitute  a  course. 

It  is  believed,  however,  that  a  course  in  “risk-bearing”  has  a 
stronger  justification  than  administrative  convenience.  The  connect¬ 
ing  thread  which  runs  through  all  the  material  is  the  influence  of 
uncertainty.  Indeed,  it  might  be  clearer  to  designate  the  course  as  a 
study  of  the  influence  of  uncertainty  on  business  affairs.  Throughout 
most  of  our  academic  work  in  business  management,  emphasis  is 
laid  upon  the  importance  of  certainty.  We  are  constantly  reiterating 
the  fact  that  efficient  management  involves  scientific  investigation 
to  determine  the  important  facts  which  bear  upon  our  problems  and 
careful  study  to  insure  that  our  plans  shall  reflect  the  significance  of 
these  facts.  The  author  has  no  desire  to  minimize  the  force  of  this 
teaching.  Nevertheless,  there  are  definite  limits  to  the  application  of 
scientific  method  in  business.  As  is  pointed  out  in  detail  in  chapter 
iii,  it  is  the  persistent  element  of  uncertainty  which  makes  necessary 
the  exercise  of  business  judgment,  and  makes  possible  the  reaping  of 
business  profit.  The  principal  topics  of  this  course,  business  fore¬ 
casting,  investment  and  speculation,  and  insurance,  serve  well  to 
bring  out  the  difference  between  the  two  fundamental  bases  for  a 
judgment  of  probability,  on  the  one  hand  formulations  of  mathematical 
probabilities  based  on  careful  statistical  investigation,  on  the  other 
hand  the  comparison  of  data  which  are  never  sufficient  to  permit 


AUTHOR’S  PREFACE 


xm 


an  exact  estimate  of  the  chances  of  success  or  failure  from  a  given 
line  of  effort,  yet  do  suffice  to  furnish  a  basis  for  an  intelligent  choice 
of  alternatives. 

So  widespread  is  the  custom  of  including  the  bulk  of  the  contents 
of  this  course  under  the  heading  of  “  finance,  ”  that  a  further  comment 
on  the  relation  of  finance  to  risk-bearing  seems  pertinent.  It  is  quite 
possible  to  define  “finance”  so  broadly  as  to  include  under  its  sway 
much  of  the  domain  here  appropriated  for  “risk-bearing.”  Indeed, 
it  is  possible  to  bring  almost  any  business  problem  into  the  “financial ” 
category,  since  the  results  of  good  or  bad  management  almost  invari¬ 
ably,  given  time  enough,  take  the  form  of  financial  advantage  or 
disadvantage.  In  the  author’s  judgment,  however,  clearness  is  gained 
by  restricting  the  application  of  the  term  “financial”  to  such  phases 
of  business  management  as  have  to  do  with  the  acquisition  of  capital, 
the  control  of  funds,  the  repayment  of  loans,  and  similar  questions; 
in  short,  to  the  maintenance  of  an  adequate  supply  of  capital  (including 
both  that  borrowed  on  short-time  instruments  and  that  permanently 
invested).  To  include  in  “finance,”  as  has  been  done  by  some 
writers,  such  matters  as  the  question  whether  to  expand  the  scope  of 
one’s  operations  at  the  height  of  a  boom,  or  the  choice  between  two 
price  policies,  involves  an  overemphasis  on  one  set  of  factors  which 
must  be  considered  in  deciding  such  questions,  and  a  neglect  of  the 
factors  of  sales  management,  technological  efficiency,  and  risk  which 
are  more  often  effective  in  determining  action  than  are  any  financial 
considerations  concerning  the  proposed  program. 

The  section  devoted  to  the  business  cycle  illustrates  the  point 
of  view  upon  which  the  book  is  based.  Traditionally  this  subject 
has  been  assigned  to  the  student  of  banking.  Yet,  whether  we 
approach  the  problem  from  the  angle  of  business  management,  and 
inquire  what  are  the  effects  of  the  cycle  on  the  administration  of 
finances,  the  management  of  labor,  and  the  production  and  sales  policy, 
or  whether  we  approach  it  from  the  angle  of  a  student  of  economic 
theory  and  inquire  whether  the  causes  of  the  cycle  are  found  in 
financial,  market,  or  labor  conditions,  it  is  perfectly  clear  that  the 
cycle  is  not  merely  a  financial  phenomenon,  but  pervades  every 
aspect  of  our  economic  life.  The  common  aspect  of  the  problem 
which  the  cycle  imposes  upon  the  treasurer,  the  personnel  adminis¬ 
trator,  and  the  sales  manager,  is  the  element  of  uncertainty  concerning 
the  decisions  other  men  are  making.  It  is  in  each  case  as  a  risk- 


XIV 


AUTHOR’S  PREFACE 


bearer  that  the  manager  must  reckon  with  the  periodicity  of  the 
phenomena  with  which  he  deals.  The  appropriate  place  for  a  survey 
of  the  causes  of  the  cycle  and  the  methods  of  forecasting  or  controlling 
it  is  in  a  course  dealing  with  risk  and  risk-bearing;  the  appropriate 
place  for  discussion  of  the  details  of  adjustment  of  the  labor,  the 
financial,  and  the  sales  policies  to  such  forecasts,  is  in  courses  dealing 
with  those  functions. 

As  is  the  case  with  other  intermediate  courses  in  the  curriculum 
described  above,  no  attempt  is  made  to  cover  the  entire  field  in 
exhaustive  fashion.  Rather  it  is  intended  to  present  simply  the 
amount  of  material  which  every  professional  student  of  business 
can  fairly  be  expected  to  include  in  a  four  year’s  course,  which  must 
include  his  general  business  training,  his  specialized  training  for  his 
particular  line  of  endeavor,  and  whatever  of  literary  and  scientific 
education  not  strictly  vocational  he  may  secure  in  addition.  For 
example,  it  is  anticipated  that  students  taking  this  course  will  elect 
additional  work  in  investment  analysis  if  their  major  interest  is  in 
finance;  in  insurance,  if  they  expect  to  enter  that  field  of  employment; 
in  marine  insurance,  either  separately  or  in  connection  with  courses 
in  foreign  trade,  if  they  are  looking  to  foreign  commerce  as  a  field  of 
life-work,  and  so  on.1 

Although  emphasis  has  been  placed  upon  the  way  in  which  a  course 
in  risk  and  risk-bearing  dovetails  into  a  curriculum  organized  upon  a 
functional  basis,  the  attempt  has  been  to  organize  the  material  in  such 
a  way  that  it  can  be  used  effectively  with  students  having  a  different 
background.  It  is  believed  that  the  material  can  be  presented 
advantageously  to  students  having  no  other  preliminary  training  than 
the  customary  introductory  courses  in  economics.  Colleges  whose 
offerings  in  economics  and  business  are  more  limited  in  number  than 
is  the  case  with  the  professional  school  of  business  may  find  a  course 
in  risk  an  effective  way  of  reducing  the  number  of  courses  needed  to 
cover  the  fields  touched  upon,  thereby  making  possible  more  extended 
work  in  other  fields.  The  first  ten  chapters  may  be  used  conveniently 
as  the  introductory  portion  of  an  advanced  course  in  investment 
analysis.  Business  men  will  find  little  that  is  new  in  the  discussion 

1  Speculation  is  treated  somewhat  more  fully  than  this  general  plan  requires, 
with  a  view  to  making  advanced  courses  unnecessary,  chiefly  because  of  the  small 
number  of  students  interested  to  take  advanced  courses  in  this  f.eld  and  the  pau¬ 
city  of  material  for  use  in  such  courses. 


AUTHOR’S  PREFACE 


xv 


of  their  special  fields  of  work,  but  may  find  value  in  the  discussion  of 
the  interrelations  of  the  different  topics  presented. 

My  indebtedness  to  co-operating  friends  is  very  heavy.  Dean 
L.  C.  Marshall  has  incurred  a  burden  of  responsibility  for  the  appear¬ 
ance  of  a  book  dealing  with  this  field,  for  its  inception  was  due  to  his 
suggestion,  and  his  unflagging  interest  and  faith  in  the  project  made 
it  possible  for  the  material  to  be  accumulated  and  subjected  to  the 
test  of  the  classroom  in  its  earlier  as  well  as  its  later  stages  of  develop¬ 
ment.  He  has  also  made  innumerable  suggestions  of  detail  in  connec¬ 
tion  with  the  form  in  which  the  material  is  presented.  To  Professor 
F.  H.  Knight,  my  colleague  in  two  universities,  my  debt  is  also 
unusually  great,  both  for  access  to  preliminary  drafts  of  his  book, 
Risk,  Uncertainty,  and  Profit,  during  the  period  when  my  own  ideas 
on  the  subject  were  first  taking  definite  shape,  and  for  innumerable 
helpful  suggestions  and  clarifying  criticisms.  Professor  Leverett  S. 
Lyon  has  collaborated  in  the  preparation  of  chapter  xii,  and  has 
contributed  much  to  the  development  of  my  view  on  many  questions 
of  theory.  Professor  A.  S.  Keister  and  Messrs.  S.  P.  Meech  and 
L.  W.  Mints  have  used  preliminary  mimeographed  editions  as  text 
material,  and  have  given  me  the  benefit  of  their  criticisms.  Professors 
R.  W.  Stone  and  C.  W.  Wassam  and  Messrs.  W.  E.  Atkins  and  H.  C. 
Simons  have  read  portions  of  the  manuscript,  and  I  have  profited 
much  by  their  suggestions.  Grateful  acknowledgment  is  made  of  the 
hearty  co-operation  of  authors  and  publishers  in  connection  with  my 
requests  for  permission  to  use  extended  quotations.  Mr.  John  E.  Part¬ 
ington  has  rendered  efficient  aid  in  the  preparation  of  the  index. 

C.  O.  Hardy 

Iowa  City 
April  14,  1923 


:  I 


TABLE  OF  CONTENTS 


PAGE 


CHAPTER 

I.  Forms  and  Extent  of  Business  Risk . i 

Universality  of  Risk.  Sources.  Risk  in  Production  and  in 
Marketing 

II.  Ways  of  Dealing  with  Risk:  Elimination  of  the  Risk  .  io 

Methods  of  Dealing  with  Risk.  Prevention  Research. 
Market  Analysis.  Time  and  Motion  Study.  Co-operation. 
Specialization.  Combination  of  Risks.  Reserves.  Mathe¬ 
matics  of  Probability 

III.  Ways  of  Dealing  with  Risk:  Transfer  to  Others;  As¬ 
sumption  of  Risk . 32 

Specialization  in  Risk-Bearing.  The  Owner-Manager.  Profit. 

Risk  and  Control.  The  Choice  of  Administrators.  Business 
Judgment 

IV.  Ways  of  Dealing  with  Risk:  Transfer  to  Specialists — 


Continued . 56 

Insurance.  Hedging.  Contracting  Out 

V.  Uncertainty  and  the  Business  Cycle . 63 


Phases  of  the  Cycle.  Causes.  Uncertainty  in  Producers’ 
Calculations.  Uncertainty  in  Buyers’  Calculations.  The 
Cycle  in  Production  of  Basic  Capital.  In  Agricultural 
Production 

VI.  Business  Forecasting . .  .  .84 

Methods.  Interpretation  of  Prices.  Index  Numbers.  Cor¬ 
poration  Reports.  Steel  and  Iron.  Agricultural  Produc¬ 
tion.  Banking  Conditions  and  Interest  Rates.  Composite 
Barometers 

VII.  Risk  and  the  Management  of  Capitai . 116 

Ways  of  Investing.  Investment  in  One’s  Own  Business. 

In  Repayment  of  Debts.  Deposits  with  Financial  Institu¬ 
tions.  Security  Investments.  Personal  Loans.  Specula¬ 
tion.  Gambling 

xvii 


XV111 


TABLE  OF  CONTENTS 


PAGE 

VIII.  The  Security  Markets . 128 

The  Market  for  Old  Securities.  The  New  York  Stock 
Exchange.  Functions.  Trading  Methods.  Relations  of 
Brokers  with  Customers.  Deliveries.  Information.  Con¬ 
trol  of  the  Exchange.  Classes  of  Members.  Short  Selling. 

Wire  Houses.  Other  Stock  Exchanges.  Trading  Outside  the 
Exchanges.  The  Market  for  New  Securities.  Investment 
Banks.  Marketing  Low  Grade  Securities 

IX.  Stock  Speculation  as  Business  Enterprise  ,  .  .157 

Traders’  Technique.  Market  Maxims.  The  Technical 
Position.  Trading  on  the  News.  Manipulation.  Proba¬ 
bilities  of  Success.  Speculation  for  the  Long  Swing 

X.  The  Analysis  of  Securities . 181 

The  Factors  in  Security  Analysis.  Tax  Exemptions.  Mar¬ 
ketability.  Legality.  United  States  Government  Obliga¬ 
tions.  Foreign  Government  Bonds.  Industrial  Securities. 
Analysis  of  the  Industry.  Financial  Statements.  The 
Balance  Sheet.  The  Income  Statement.  Policy  and  Per¬ 
sonnel.  Railway  and  Public  Utility  Securities.  Diversifica¬ 
tion  ‘ 

XI.  Speculation  in  Commodities . 205 

Organized  and  Unorganized  Markets.  Futures  Contracts. 
Futures  Markets.  Delivery.  Direct  Settlement.  Ringing 
Out.  Transfer.  Speculators’  Methods.  Land  Speculation 

XII.  Hedging  , .  223 

Advantages  of  Hedging.  Degree  of  Protection  Afforded. 

A  Supposititious  Case.  A  Modification  of  the  Assumptions. 
Relation  of  Spot  Prices  to  Futures  Prices.  The  Normal 
Spread.  Conclusions 

XIII.  Life  Insurance . 237 

Insurance  as  a  Hedge.  The  Risk  Insured.  Policy  Contracts. 
Company  Organization.  Selection  of  Risks.  Calculation  of 
Premiums.  The  Net  Premium.  Loading.  Disbursement  of 
Funds.  Expenses.  Methods  of  Settlement.  Surrender 
Values.  Policy  Loans.  Group  Insurance.  Fraternal  In¬ 
surance.  Life  Annuities.  Disability  Clauses.  War  Risk 
Insurance 


TABLE  OF  CONTENTS 


xix 


PAGE 

XIV.  Fire  Insurance . 288 

The  Risk  Insured.  Policy  Contracts.  The  New  York 
Standard  Policy.  Mortgage  Clause.  Coinsurance.  Three- 
quarter  Value  and  Three-quarter  Loss  Clauses.  Use  and 
Occupancy  Insurance.  Company  Organization  Stock. 
Mutual.  Lloyd’s.  Reciprocal.  Rate  Making.  Public 
Control 

XV.  Miscellaneous  Property  Insurance . 320 

Marine  Insurance.  Tornado.  Automobile.  Crop.  Credit. 
Miscellaneous  Lines 

XVI.  Guaranty  and  Suretyship . 327 

Suretyship  Compared  with  Insurance.  Corporate  Surety¬ 
ship.  Advantages.  Types  of  Protection.  Insurance  of 
Real  Estate  Titles.  Bonded  Abstracters.  Title  Guaranty. 
Torrens  System 

XVII.  Risks  of  Labor . 336 

Types  of  Risk  Carried  by  Labor.  Unemployment.  Sources. 

Cost.  Ways  of  Dealing  with  Unemployment.  Risk  of 
Accident  and  Occupational  Disease.  Employers’  Liability. 
Workmen’s  Compensation.  Benefits.  Compensation  Insur¬ 
ance 

XVIII.  Social  Aspects  of  Risk-Bearing . 355 

Profit  Taking.  Social  Interference  with  Monopoly  Profits. 

Dangers  in  Limiting  Profits.  A  Fair  Return.  Profiteering. 

Risk  and  Control.  Ethics  of  Gambling.  Ethics  of  In- 

« 

surance.  Ethics  of  Speculation.  Risk-Bearing  and  the 
Social  Order.  Risks  of  Modern  Industry  Compared  with 
Medieval.  Risk  under  Socialism 


CHAPTER  I 

4 

FORMS  AND  EXTENT  OF  BUSINESS  RISK 

Risk  may  be  defined  as  uncertainty  in  regard  to  cost,  loss,  or 
damage.  In  this  definition,  emphasis  is  on  the  word  uncertainty. 
Where  destruction  or  loss  of  capital  is  certain  in  connection  with  a 
business  process,  it  can  be  charged  up  in  advance  as  a  cost.  It  is  not 
a  risk.  When  the  destruction  or  loss  is  uncertain,  it  may  be  dealt  with 
in  accordance  with  judgments  of  probability,  and  presents  a  problem 
in  risk.  In  this  chapter  our  task  is  to  make  a  preliminary  survey  of 
the  forms  and  extent  of  risk  involved  in  present-day  economic  life. 

It  is  a  common  statement  that  risk  is  universal.  As  one  author 
puts  it: 

The  owner  of  wealth  must,  if  he  is  rational,  invest  it  in  some  productive 
enterprise,  unless,  under  the  circumstances,  he  decides  to  consume  it;  and, 
wherever  it  is  invested,  there  will  be  some  risk  that  part  of  it  will  be  lost 
by  the  dishonesty  of  others,  the  deterioration  in  value  of  the  property  in 
which  it  is  embodied,  or  in  change  of  value  of  the  standard  of  deferred 
payment.  If  he  thinks  to  escape  by  hoarding  it  in  the  shape  of  specie, 
robbery  is  to  be  feared,  to  say  nothing  of  the  opportunities  of  gain' which 
are  given  up.  If  he  decides  to  consume  the  wealth  at  once,  he  runs  the  risk  of 
coming  to  poverty.1 

Or,  in  Professor  Fisher’s  words: 

If  we  take  the  history  of  the  prices  of  stocks  and  bonds,  we  shall  find  it 
chiefly  to  consist  of  a  record  of  changing  estimates  of  futurity,  due  to  what 
is  called  chance,  rather  than  of  a  record  of  the  foreknown  approach  and 
detachment  of  income.  Few,  if  any,  future  events  are  entirely  free  from 
uncertainty.  In  fact,  property,  by  its  very  definition,  is  simply  the  right  to 
the  chance  of  future  services.  A  mine  owner  takes  his  chances  as  to  what 
the  mine  will  yield;  the  owner  of  an  orange  plantation  in  Florida  takes 
risks  of  winter  frosts;  the  owner  of  a  farm  takes  risks  as  to  the  effect  of 
sun  and  rain  and  other  meteorological  conditions,  as  well  as  risks  of  ravages 
of  fire,  insects,  and  other  pests.  In  buying  an  overcoat  a  man  takes  some 
risk  as  to  its  effectiveness  in  excluding  cold,  and  as  to  the  length  of  time  it 
will  continue  to  be  serviceable.2 

1  John  Haynes,  “Risk  as  an  Economic  Factor,”  Quarterly  Journal  of  Economics , 
IX,  410. 

2  Irving  Fisher,  Nature  of  Capital  and  Income ,  pp.  265-66. 


2 


RISK  AND  RISK-BEARING 


Statements  such  as  these,  though  strictly  accurate,  are,  neverthe¬ 
less,  apt  to  give  a  false  impression  of  the  extent,  or  rather  of  the 
importance,  of  the  unknown  element  in  human  calculations.  All  these 
manifold  risks  do  exist,  but  most  of  them  are  of  no  practical  conse¬ 
quence.  The  only  risks  which  need  be  given  consideration  in  a 
business  decision,  or  for  that  matter  in  any  other  decision,  are  the 
cases  where  the  property  interest,  or  other  interest,  at  stake  on  the 
outcome  of  a  single  uncertainty  is  large  relative  to  the  total  of  which 
it  is  a  part.  For  example,  the  risk  of  windows  being  broken  by  small 
boys  is  a  real  risk  for  owners  of  expensive  plate  glass  windows  but  is 
of  no  practical  significance  to  owners  of  an  equally  large  amount  of 
capital  in  the  form  of  many  small  windows.1  Risk  in  any  practical 
sense  is  not  present  in  all  our  calculations. 

Uncertainties  of  practical  importance  to  the  business  manager  may 
conveniently  be  classified  in  accordance  with  their  origin,  as  follows: 

1.  Risks  of  destruction  of  property  through  the  physical  hazards  of 
nature:  storm,  flood,  fire,  etc.  These  are  among  the  most  serious 
hazards  in  many  lines  of  business,  notably  in  live  stock  raising  and 
in  transportation.  Most  of  the  losses  caused  by  hail,  flood,  and  storm 
would  be  avoided  if  we  knew  in  advance  what  conditions  to  expect. 
They  are  part  of  the  cost  of  our  ignorance.  To  measure  the  total 
cost,  however,  we  must  add  to  the  actual  losses  the  cost  of  precautions 
taken  against  disasters  which  never  occurred,  and  the  loss  of  produc¬ 
tion  on  account  of  the  existence  of  these  risks. 

The  magnitude  of  these  losses  reflects  primarily  the  extremely 
rudimentary  development  of  our  science  of  weather  forecasting. 
The  extreme  range  of  our  ability  to  forecast  deviations  of  weather 
from  its  past  average  is  less  than  a  week,  and  tolerably  accurate 
forecasts  can  be  made  only  twenty-four  to  forty-eight  hours  in  advance. 
Even  this  limited  range  of  forecasting,  however,  has  tremendously 
reduced  the  volume  of  losses  from  weather  conditions. 

2.  Closely  related  to  the  preceding  are  uncertainties  in  the  productive 
process. — In  spite  of  the  immense  advance  in  applied  science  in  the 
past  150  years,  there  still  remain  numerous  points  where  commitment 
of  capital  is  based  on  uncertainties.  Strength  of  materials  is  one  such 

1  Of  course  in  the  illustration  given  the  coincidental  breaking  of  all  the  small 
windows  is  a  theoretical  possibility,  and,  if  it  occurred,  would  be  quite  as  serious 
as  the  breaking  of  the  one  large  one.  The  point  is  that  such  coincidences  are  so 
extremely  rare  that  their  possibility  may  be  disregarded  entirely.  The  justifica¬ 
tion  for  this  treatment  of  infinitesimal  risks  is  developed  more  fully  in  chap,  ii, 
note  1. 


FORMS  AND  EXTENT  OF  BUSINESS  RISK 


3 


weak  point  in  our  applied  science,  particularly  in  the  case  of  materials 
which  have  suffered  depreciation  in  use.  The  effectiveness  of  labor  is 
another  point  at  which  advance  estimate  and  final  result  are  apt  to 
vary,  and  variations  of  weather  make  agricultural  production  notori¬ 
ously  speculative. 

3.  Social  hazards  include  the  risks  due  to  deviations  of  individual 
conduct  from  what  is  expected ,  such  as  robbery,  defalcation,  and  forgery, 
and  also  risks  due  to  the  impossibility  of  predicting  the  behavior  of 
social  groups.  Strikes,  riots,  wars,  tariff  changes,  tax  reforms,  pro¬ 
hibitory  laws  illustrate  the  range  of  these  risks. 

4.  Risks  due  to  individual  ignorance  cause  many  losses  and  make 
possible  many  profits. — In  a  sense  all  risks  are  due  to  ignorance,  for 
if  all  the  conditions  of  any  situation  were  known  there  would  be  no 
risk  involved  in  it  for  anyone.  There  is,  however,  a  distinction  worth 
maintaining  between  risks  due  to  the  limitations  of  human  knowledge 
and  risks  which  are  due  to  the  failure  or  inability  of  individuals  to  take 
advantage  of  the  knowledge  which  is  accessible  to  themselves  or  to 
those  with  whom  they  come  into  competition.  It  is  risk  of  this 
character  which  keeps  down  the  competition  to  seize  favorable  busi¬ 
ness  openings  and  makes  it  possible  for  persons  of  superior  knowledge 
and  skill  to  profit  by  their  superiority.  Potential  competitors  are 
kept  out  of  the  field  by  their  ignorance  of  its  existence  or  its  extent, 
and  many  who  do  enter  are  unable  to  compete  effectively. 

5.  Market  risks  form  the  most  important  group  of  all. — By  market 
risks  we  mean  the  unavoidable  uncertainties  due  to  the  fact  that  time 
elapses  between  the  purchase  and  the  sale  of  commodities,  during 
which  time  unpredictable  changes  often  occur  in  the  prices  and  other 
market  conditions  surrounding  the  commodities  dealt  in.  Rarely  is 
it  possible  to  conclude  both  the  buying  and  the  selling  part  of  a 
given  transaction  simultaneously,  so  as  to  relieve  the  business  man 
of  risk,  and  even  when  it  can  be  done  there  is  risk  that  he  will  be  held 
to  one  contract  and  be  unable  to  enforce  the  other. 

The  extent  to  which  the  time  element  makes  business  risky  has 
been  indicated  by  President  Hadley: 

Down  to  the  present  century,  a  large  part  of  the  speculative  profits  were 
made  by  taking  advantage  of  differences  of  price  in  different  places — chiefly 
in  connection  with  foreign  trade.  The  means  of  communication  and  trans¬ 
port  were  so  defective  that  there  was  often  a  great  scarcity  of  an  article  in 
one  region  and  an  abundance  of  the  same  article  in  another.  The  shipowners 
who  moved  the  article  from  the  latter  place  to  the  former  had  a  chance  of 


4 


RISK  AND  RISK-BEARING 


enormous  profits.  But  the  business  was  also  attended  by  great  risk. 
Transportation  was  far  less  safe,  either  from  the  elements  or  from  human 
violence,  than  it  is  today.  There  was  no  telegraph,  no  good  postal  service, 
no  efficient  protection  from  pirates  by  sea  or  highway  robbers  by  land. 
All  these  causes  combined  to  render  the  arrival  of  goods  so  uncertain  that 
the  very  wages  of  the  seamen  were  made  contingent  upon  the  safe  delivery 
of  the  cargo,  and  the  whole  body  of  sailors  thus  became  participants  in  the 
speculation. 

The  nineteenth  century  has  witnessed  a  change  in  these  respects. 
Improved  means  of  communication  have  greatly  lessened  the  differences  in 
price  in  different  markets.  It  is  no  longer  possible  to  have  a  glut  of  wheat 
in  Chicago  and  a  scarcity  in  Liverpool.  The  modem  post-office  and  the 
telegraph  furnish  prompt  information  of  what  is  going  on  all  over  the 
world  and  enable  merchants  to  know  where  goods  are  most  needed.  The 
steamship  and  the  railroad  furnish  a  quick  and  safe  means  of  placing  the 
goods  where  they  will  meet  such  needs  as  may  arise.  The  difference  of 
price  of  any  staple  article  in  two  large  wholesale  markets  will  not  generally 
be  much  greater  than  the  cost  of  transportation  from  one  to  the  other. 
So  moderate  have  the  profits  from  this  source  become  that  the  business  of 
those  who  try  to  secure  them  is  now  known  as  arbitrage  rather  than  specula¬ 
tion.  Only  in  the  trade  with  barbarous  or  half-civilized  races  does  foreign 
commerce  retain  its  character  as  an  extra-hazardous  business. 

The  speculator  of  today  makes  his  money  chiefly  by  taking  advantage 
of  differences  of  price  between  different  limes  rather  than  between  different 
markets.  It  is  not  so  much  the  difference  in  the  price  of  wheat  in  Chicago 
and  in  Liverpool  which  furnishes  the  source  of  his  profits,  as  the  difference 
between  its  price  in  Chicago  this  month  and  next  month.  When  such 
speculation  anticipates  an  actual  demand,  it  is  of  great  service  to  the  com¬ 
munity.  The  long  time  which  elapses  between  production  and  consump¬ 
tion,  between  contracts  and  their  fulfilment,  makes  it  extremely  important 
to  have  responsible  men  to  anticipate  the  wants  of  the  market  and  take  the 
risks  on  their  own  shoulders.1 

It  will  be  noted  that  from  the  standpoint  of  risk  it  makes  no 
difference  whether  the  buying  or  the  selling  occurs  first.  In  many 
cases  the  business  man  contracts  to  deliver  a  certain  commodity  at  a 
given  price,  then  purchases  the  things  he  needs  to  fulfil  his  contract. 
The  sale  of  a  newspaper  subscription,  a  building  contract,  the  collec¬ 
tion  of  university  tuition,  are  all  transactions  of  this  character.  More 
frequent  are  the  transactions  where  something  is  bought  first  with  the 
idea  of  selling  it,  or  some  product  into  which  it  enters,  at  a  profit. 

‘Adapted  by  permission  from  A.  T.  Hadley,  Economics,  pp.  104-5.  (G.  P. 

Putnam’s  Sons,  1899.) 


FORMS  AND  EXTENT  OF  BUSINESS  RISK 


5 


Sometimes  both  elements  are  present  in  the  same  transaction,  as  when 
a  tailor  first  buys  cloth,  then  after  taking  an  order  for  a  suit,  buys  the 
labor  to  make  it  up.  In  all  transactions  of  either  of  these  types,  and 
it  must  be  repeated  that  practically  all  business  is  of  one  type  or  the 
other,  the  longer  the  time  involved  in  the  fulfilment  of  obligations 
entered  into,  or  in  the  disposal  of  commodities  bought,  the  greater 
the  risk  of  adverse  changes,  either  in  price  or  in  other  market  condi¬ 
tions.  Declines  in  price  of  one’s  product  occurring  after  capital  has 
been  sunk  in  plant  and  inventory  have  probably  ruined  more  businesses 
than  any  other  single  group  of  causes.  Increases  in  cost  of  materials 
and  labor  after  contracting  to  sell  one’s  product  are  sometimes  equally 
disruptive.  Such  changes  in  prices  may  be  due  to  decline  of  demand 
arising  from  a  change  of  consumers’  tastes — the  collapse  of  the  Ameri¬ 
can  Bicycle  Company  is  a  good  illustration;  or  to  appearance  of  a 
more  efficient  method  of  production,  as  in  the  supplanting  of  hand 
weaving  by  factory  processes;  or  to  the  appearance  of  a  rival  com¬ 
modity  which  renders  a  superior  service,  as  when  the  tungsten  filament 
supplanted  the  carbon  for  electric  lighting  purposes;  or  to  changes 
in  the  general  level  of  prices,  as  is  illustrated  by  the  decline  of  gold¬ 
mining  during  recent  years  of  advancing  prices. 

Of  course  the  conditions  which  give  rise  to  the  chance  of  adverse 
changes  also  bring  the  chance  of  favorable  changes.  When  the 
probability  of  such  unpredictable  changes,  one  way  or  the  other,  is 
considerable,  and  business  is  entered  into  with  a  view  to  profiting  by 
a  preponderance  of  favorable  changes,  the  business  is  said  to  be  of  a 
speculative  character.  If  the  capital  invested  is  highly  specialized, 
the  speculative  element  is  increased  because  of  the  impossibility  of 
recovering  the  investment  if  things  go  wrong  with  it.  Real  estate, 
grain,  cotton,  fresh  fruit  and  vegetables,  sugar,  live  cattle  and  hogs, 
horses  are  dealt  in  largely  as  speculative  commodities,  though  in 
marketing  many  of  these  commodities  it  is  feasible  to  reduce  the 
speculative  element  in  business  by  “hedging.”  (See  chap,  xii.) 

In  most  lines  of  business  profit  does  not  depend  upon  favorable 
changes  in  the  market,  and  the  owner-manager  would  gladly  give 
up  his  chance  of  profit  from  fluctuations  of  the  market  for  the  sake 
of  freedom  from  its  risks.  The  fluctuations,  like  the  physical  hazards 
referred  to  above,  are  a  disturbing  element,  and  though  they  may 
give  rise  to  as  many  gains  as  losses,  the  necessity  of  taking  precautions 
against  them  involves  a  cost  which  is  a  dead  loss  to  the  group  as  a 
whole.  In  strictly  speculative  lines,  on  the  other  hand,  the  fluctua- 


6 


RISK  AND  RISK-BEARING 


lions  are  the  chifef  source  of  profit,  though  here  also  they  may  give 
rise  to  as  many  losses  as  gains. 

In  relatively  few  cases  does  a  highly  speculative  business  derive 
its  character  from  uncertainties  in  the  productive  process.  Mining 
and  oil-drilling  furnish  the  best  examples  of  this  sort  of  risk.  The 
development  of  inventions  is  highly  speculative,  partly  because  of 
market  considerations  and  partly  from  uncertainties  connected  with 
production. 

The  following  comparison  of  the  uncertainties  involved  in  produc¬ 
tion  and  in  marketing  brings  out  other  reasons  for  the  emphasis  which 
has  been  laid  on  the  market  as  a  source  of  risk: 

In  the  field  of  production,  of  course,  the  body  of  knowledge  is  on  the 
whole  better  organized  and  more  precise.  The  various  systems  of  manage¬ 
ment  relate  more  to  production  than  to  marketing. 

Though  a  vast  field  for  research,  marketing  has  had  comparatively 
little  scientific  study.  It  has  not  seemed  particularly  susceptible  to  scientific 
study.  It  abounds  in  the  human  equation.  This  does  not  mean  that  much 
ability  has  not  been  expended  on  this  field  not  only  in  studying  and  inciting 
demand  but  also  in  recording  performance.  Map  and  tack  systems,  quotas 
and  bonuses,  selling  costs  and  carefully  prepared  statistics  of  various  kinds 
have  for  a  considerable  period  been  employed  by  the  most  progressive  selling 
organizations.  These  internal  statistics  have  also  been  accompanied  by 
external  statistics  affecting  and  reflecting  market  conditions.  But  in  the 
last  analysis,  the  figures  finally  used  in  marketing,  however  obtained,  are 
based  on  the  law  of  averages,  frequency,  or  proportion;  the  standards  set, 
no  matter  how  carefully  and  specifically  adjusted,  are  in  the  last  analysis 
averages,  modes,  or  proportions  and  apply  en  masse  rather  than  in  detail. 
This  does  not  mean  that  these  data  are  not  regarded  as  exceedingly  valuable. 
Nevertheless  a  great  problem  in  marketing  is  to  get  down  beneath  the  law 
of  averages  and  types. 

Production  is  so  much  more  specialized  and  standardized,  so  much 
more  precise  than  marketing,  that  it  is  possible,  given  certain  facts  of 
material,  dimension,  and  design,  to  set  a  maximum  time  for  the  performance 
of  a  certain  specific  operation.  The  appliers  of  scientific  management  have, 
furthermore,  shown  the  possibility  of  determining  a  minimum  time  for  this 
operation  with  conditions  continuing  the  same  and  of  prescribing  the  means 
whereby  this  minimum  time  need  not  be  exceeded.  In  other  words,  the 
scientific  manager  in  production  cannot  only  tell  William  Jones  how  long 
he  should  be  in  machining  a  certain  part,  but  can  furnish  him  with  the  best 
feeds  and  speeds  to  employ  in  doing  the  work  in  the  time  specified,  and  if 
the  methods  and  time  apply  in  Philadelphia  it  is  presumed  that  they  will 
also  apply  in  Boston.  But  in  marketing,  no  manager,  no  matter  how  able 


FORMS  AND  EXTENT  OF  BUSINESS  RISK 


7 


and  experienced,  would  attempt  to  tell  Thomas  Smith  how  long  he  should 
be  in  selling  a  pair  of  shoes  to  William  Jones,  nor  to  give  more  than  general 
instructions  as  to  the  best  way  in  which  to  do  the  selling.  About  the  best 
this  manager  has  been  able  to  do  is  to  say  that  in  a  week,  on  the  average 
and  according  to  the  season,  Thomas  Smith  should  sell  so  many  dollars’ 
worth  of  shoes.  In  machining  the  part,  the  conditions  are  more  stand¬ 
ardized,  the  operation  more  specialized,  the  human  factor  is  smaller  and  is 
more  under  control.  In  selling  the  shoes,  the  opposite  is  true.  In  produc¬ 
tion,  the  time  for  an  operation  can  be  measured  by  minutes  and  less;  in 
marketing,  I  have  encountered  no  practical  use  being  made  of  units  of  less 
than  one  week. 

This  warrants  the  consideration  for  a  moment  of  certain  fundamental 
differences  between  production  and  marketing.  These  differences  may  be 
balanced  against  each  other  as  follows.  In  production,  men  meet  only  as 
members  of  the  business — as  subordinates,  peers,  or  superiors.  Neither 
the  customer  nor  the  competitor  is  encountered  directly.  In  marketing, 
on  the  other  hand,  men  are  in  contact  not  only  with  the  other  members 
of  the  business,  but  also  with  the  customer  to  serve  and  the  comnetitor  to 
meet.  In  production,  the  problems  are  likely  to  be  more  those  of  cost — 
material,  labor,  and  overhead.  In  marketing,  the  attention  is  more  focused 
on  price.  Knowledge  of  cost  is  not  particularly  essential.  The  market  is 
fixing  values  outside  of  the  business’  control.  Emphasis  is  also  likely  to 
be  laid  on  quality  and  service.  In  production,  the  problems  on  the  whole 
are  internal.  In  marketing,  the  problems  on  the  whole  are  external.  Com¬ 
petition  is  on  every  hand.  The  market  is  to  be  analyzed.  In  production, 
there  is  probably  for  the  individual  business  a  possibility  of  greater  inde¬ 
pendence  of  action.  Marketing  is  probably  more  hedged  about  by  the 
customs  of  the  trade.  In  other  words,  as  said  before,  marketing  abounds 
in  the  human  equation.1 

The  last  sentence  in  the  preceding  selection  touches  one  of  the 
fundamental  and  irremovable  elements  of  uncertainty  in  the  business 
man’s  problem.  “Business  touches  the  human  equation.”  That  is, 
the  decision  of  a  business  problem  depends  on  a  judgment  as  to  what 
certain  individuals  will  do  under  given,  or  partially  given,  circum¬ 
stances.  This  is  always  fraught  with  uncertainty,  if  for  no  other 
reason  because  if  A’s  decision  depends  on  what  B  will  do,  and  B’s 
decision  on  what  A  will  do,  ;t  is  obviously  impossible  for  both  to  get 
all  the  data  they  need.  The  only  way  in  which  one  can  arrive,  even 
in  theory,  at  a  scientific  solution  is  through  a  rigid  exclusion  of  free 

1  Adapted  by  permission  from  S.  O.  Martin,  “Scientific  Study  of  Marketing,” 
in  Annals  of  the  American  Academy  of  Political  and  Social  Science ,  LIX  (1915), 
78-80. 


8 


RISK  AND  RISK-BEARING 


choice  from  his  interpretation  of  human  conduct;  but  on  such  an 
interpretation  the  business  manager  himself  would  have  no  interest 
in  the  result  of  his  analysis  anyway,  as  his  own  action  would  be 
determined  outside  his  own  choice. 

Moreover,  quite  apart  from  the  theoretical  impossibility  of  arriv¬ 
ing  at  a  scientific  judgment  in  matters  of  human  conduct,  the  business 
manager  runs  quickly  into  serious  practical  difficulties.  Time  and 
cost  set  limits  to  the  extent  of  his  researches.  No  more  than  a  general 
in  the  field  can  he  wait  till  all  the  relevant  facts  have  been  gathered, 
nor  can  he  afford  to  spend  in  their  collection  an  amount  greater  than 
they  will  add  to  his  profits.  Even  these  limits  he  cannot  definitely 
know.  How  much  time,  how  much  money  it  is  worth  while  to  spend 
in  trying  to  complete  the  data  on  which  to  base  a  given  decision, 
depends  on  facts  which  frequently  cannot  be  known  till  the  investiga¬ 
tion  is  complete  and  the  decision  has  been  made. 

In  other  words,  the  choice  between  two  business  policies  or  lines 
of  action  is  in  most  cases  not  comparable  to  the  solution  of  an  algebraic 
equation,  a  type  of  problem  where  two  trained  minds  may  be  expected 
to  arrive  invariably  at  the  same  conclusion.  Sometimes  it  is  rather 
like  the  translation  of  an  inscription  on  a  defaced  monument  where 
some  of  the  words  can  be  deciphered  with  ease,  some  can  be  made 
out  with  the  aid  of  photography,  and  some  can  only  be  conjectured. 
Sometimes  it  is  like  a  question  of  ethnography,  where  the  expense  of 
collecting  data  concerning  an  uncivilized  race  may  make  it  necessary 
to  depend  on  the  unconfirmed  accounts  of  a  few  travelers.  Sometimes 
it  is  like  the  decision  of  a  general  in  the  field,  where  action  must  be 
taken  at  once,  without  waiting  for  the  much  desired  information  to 
arrive. 

The  conclusion  is  not,  however,  that  since  we  cannot  know  all  we 
would  like  to  know  we  cannot  conduct  ourselves  rationally.  If  time 
or  cost  prevents  our  reaching  a  valid  final  judgment,  there  still  remain 
several  ways  of  meeting  the  situation.  To  these  we  will  give  atten¬ 
tion  in  chapter  ii. 

QUESTIONS 

1.  “The  grower,  the  manufacturer,  and  the  merchant  must  speculate.” 
Why? 

2.  Are  risks  greater  in  a  changing  condition  of  industry?  in  a  market  of 
greater  time  area  ? 

3.  Commercial  speculation  may  concern  itself  either  with  the  time  area  or 
the  space  area  of  the  market.  Explain. 


FORMS  AND  EXTENT  OF  BUSINESS  RISK 


9 


4.  How  does  the  “ roundaboutness ”  of  modern  industry  affect  risks? 

5.  Explain  how  the  presence  of  highly  specialized  capital  goods  in  modern 
industry  accentuates  risk. 

6.  Does  expanding  education  have  any  tendency  to  increase  risk  ? 

7.  How  has  the  development  of  improved  transportation  and  commu¬ 
nication  affected  risk  ? 

8.  Do  you  gather  that  risks  are  increasing?  Is  there  any  answer  to  this 
question?  Suppose  they  are  increasing;  is  society  worse  off? 

9.  “Business  touches  the  human  equation.”  Explain. 

10.  Try  to  outline  what  would  be  involved  in  a  complete  elimination  of 
significant  risk  in  our  business  life. 


CHAPTER  II 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 

OF  THE  RISK 

It  is  clear  enough  that  there  is  no  escape,  present  or  future,  from 
the  presence  of  uncertainty  in  the  administration  of  business,  and  that 
we  must  accordingly  deal  with  risk.  The  elimination  of  the  risk 
requires  the  elimination,  not  of  the  loss  or  damage  itself,  but  of  the 
uncertainty  concerning  its  time  or  place  or  extent.  Usually  this 
involves  the  substitution  for  the  uncertain  loss  of  a  smaller  but  certain 
loss  in  one  form  or  another.  This  cost,  for  instance,  may  consist  of 
the  price  of  a  safety  device,  which  may  never  be  used  or  needed  but 
if  it  is  needed,  may  save  many  times  its  cost — it  may  be  an  insurance 
premium,  or  it  may  be  the  cost  of  an  investigation  to  remove  the 
uncertainty. 

Methods  of  dealing  with  risk  may  be  analyzed  into  the  following 
types: 

A.  Elimination  of  risk  by: 

1.  Prevention  of  the  harmful  events 

2.  Forecasting,  or  research  to  remove  the  uncertainty 

3.  Combination  of  risks 

4.  Accumulation  of  reserves  to  provide  for  meeting  the  risks 

5.  “Compensation,”  or  offsetting  of  risks 

B.  Assumption  of  Risk 

1.  By  owner-managers 

2.  By  investors  and  speculators 

3.  By  laborers 

C.  Transfer  of  risks  to  others 

1.  Transfer  to  entrepreneurs,  from 

(a)  Laborers,  through  the  wage  system 

( b )  Capitalists,  through  the  interest  system 

2.  Contracting  out 

3.  Hedging 

4.  Insurance 

5.  Guaranty,  suretyship,  underwriting,  etc. 


10 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


II 


The  present  chapter  deals  with  the  various  methods  of  eliminating 
risk. 

1.  The  prevention  of  harmful  events  is  an  ancient  and  universal 
method  of  reducing  risk. — No  very  detailed  discussion  of  this  method 
of  dealing  with  risk  is  necessary.  Umbrellas,  lightning  rods,  fireproof 
walls,  and  burglar  alarms  furnish  everyday  illustrations.  Science  and 
invention  are  constantly  improving  our  technique  for  the  removal  of 
risk  by  prevention  of  harmful  events,  sometimes  by  the  development 
of  new  methods,  oftener  by  what  is  quite  as  important,  the  reduction 
of  the  cost  of  old  methods. 

2.  Reduction  of  risk  by  research  has  greatly  increased  in  impor¬ 
tance. — As  civilization  advances  the  relative  importance  of  science 
grows.  On  the  one  hand,  the  mass  of  accumulated  information  and 
experience  requires  more  study  and  more  specialization  for  its  mastery; 
on  the  other  hand,  the  complexity  of  the  problems  to  be  handled,  the 
magnitude  of  the  enterprises  to  be  controlled,  make  such  mastery 
ever  more  necessary.  Just  as  in  the  latter  part  of  the  Middle  Ages  the 
trained  lawyer  gained  control  of  the  administration  of  justice,  and  a 
little  later  the  physician  wrested  physic  from  the  barber,  so  in  the 
nineteenth  and  twentieth  centuries  the  construction  engineer  sup¬ 
plants  or  directs  the  rule-of-thumb  contractor,  the  works  engineer 
who  grew  up  in  the  plant  gives  way  to  the  engineer  with  technical 
training,  the  trained  nurse  ousts  the  “practical  nurse.”  The  increas¬ 
ing  importance  of  science  in  business  is  merely  one  illustration  of 
its  increasing  importance  in  all  human  affairs. 

The  same  factors  which  have  brought  about  the  development  of 
scientific  method  in  other  fields  have  been  operative  in  the  field  of 
business  management,  and  here  as  in  other  fields  the  recognition  of 
the  value  of  exact  knowledge  and  intelligent  planning,  though  recent, 
has  been  very  rapid.  Whether  the  problem  in  hand  is  that  of  choos¬ 
ing  a  location,  promoting  an  official,  canceling  a  purchase  order,  refund¬ 
ing  a  bond,  or  writing  an  advertisement,  the  business  manager  has  a 
choice  of  the  two  methods  of  procedure — snap  judgment  based  on 
tradition,  personal  experience,  haphazard  information,  and  the  cir¬ 
cumstances  of  the  moment,  or  careful  judgment  based  on  investiga¬ 
tion  of  all  the  available  data.  So  far  as  may  be,  he  should  rely  upon 
the  latter.  One  of  the  principal  functions  of  formal  education  for 
business,  indeed,  is  to  indicate  the  value  in  business  of  modern  methods 
of  scientific  analysis  in  such  varied  forms  as  the  development  of  com¬ 
mercial  research  for  the  management  of  the  market;  of  psychological 


12 


RISK  AND  RISK-BEARING 


and  social  investigation  as  a  guide  in  the  administration  of  personnel 
problems;  of  time  study,  laboratory  analysis,  and  other  technical 
methods  of  attack  on  the  technical  problems  of  production;  of  cost 
accounting  as  a  guide  in  directing  business  policies. 

The  following  selections  describe  certain  aspects  of  the  trend  of 
business  in  recent  years  toward  more  exact  scientific  methods: 

MARKET  ANALYSIS1 

In  order  to  determine  to  what  particular  class  of  customers  his  sales 
campaign  should  be  directed,  a  manufacturer  finds  it  necessary  to  study 
his  market  carefully  under  present  conditions  of  keen  competition.  Blun¬ 
derbuss  methods  are  wasteful;  hence  they  are  becoming  antiquated.  The 
demand  for  any  article  varies  according  to  purchasing-power,  living  condi¬ 
tions,  occupations,  racial  characteristics,  climatic  conditions,  and  numerous 
other  influences  affecting  the  different  classes  of  consumers.  The  object  of 
market  analysis  is  to  determine  which  class  or  classes  of  consumers  con¬ 
stitute  the  potential  market  for  the  product,  to  ascertain  where  that  class 
is  located,  and  to  find  out  what  channels  of  distribution  are  most  readily 
available  for  reaching  them. 

There  are  few,  if  any,  commodities  for  which  equal  per  capita  sales 
may  be  expected  in  all  sections  of  the  market,  provided  the  market  is  more 
than  local  in  its  scope.  In  each  district  there  are  numerous  classes  of 
consumers  with  widely  different  tastes  and  desires,  and  the  relative  pro¬ 
portions  of  these  classes  in  different  districts  always  vary.  In  New  York 
City,  for  example,  the  population  of  the  metropolitan  district  in  1910  was 
6,475,000.  In  the  same  year  the  population  of  the  Cleveland  metropolitan 
district  was  613,000.  From  these  figures  it  cannot  be  assumed  that  the 
New  York  market  for  any  particular  article  is  potentially  ten  times  as 
great  as  that  of  Cleveland.  New  York  represents  the  extremes  of  wealth 
and  poverty.  Fifth  Avenue  and  the  Lower  East  Side  are  at  opposite  ends 
of  the  economic  scale.  Their  wants  and  their  purchasing  power  are  wholly 
unlike  and  each  differs  from  the  large  middle-class  strata.  In  Cleveland 
the  relative  proportions  of  these  several  classes,  with  their  numerous  grada¬ 
tions  of  purchasing  power  and  of  wants,  are  not  the  same  as  in  New  York. 
The  population  of  Cleveland,  furthermore,  differs  in  its  composite  parts  from 
that  of  Cincinnati  or  other  cities,  and  these  differences  in  the  make-up  of 
the  population  affect  potential  demand.  Another  line  of  demarcation  is 
between  urban  and  rural  districts.  Because  of  these  diversities  a  reliable 
estimate  of  potential  demand  can  seldom  be  made  upon  a  gross  per  capita 
basis. 

In  analyzing  the  market  for  some  products,  conditions  other  than  those 
of  a  strictly  personal  nature  must  be  taken  into  account.  A  manufacturer 

1  Adapted  by  permission  from  M.  T.  Copeland,  Business  Statistics ,  pp.  178-83. 
(Harvard  University  Press.) 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


13 


of  electric  flat-irons,  for  example,  in  analyzing  his  market  found  that  in 
one  city  of  300,000  population  25,000  families  were  supplied  with  central 
station  electric  current.  Thus  there  were  25,000  possible  customers  in 
that  city.  In  another  city  of  approximately  the  same  size  only  3,000  families 
were  supplied  with  electric  current;  hence  the  potential  market  in  this 
second  city  was  much  smaller. 

For  some  products  the  market  is  clearly  denned;  in  such  cases  the 
market  is  easily  analyzed  by  the  manufacturer.  The  manufacturer  of 
machine  tools,  for  example,  knows  that  his  product  can  be  sold  only  to 
machine  shops  and  engineering  works  and  his  task  is  to  learn  all  the  establish¬ 
ments  existing  and  planned  for  in  the  territory  that  he  wishes  to  cover  with 
his  sales  organization.  A  similar  situation  confronts  other  producers  of 
equipment  and  materials  that  are  sold  to  manufacturers.  Certain  manu¬ 
facturers  of  specialties  sold  to  other  classes  of  customers  can  encompass 
their  market  in  a  list  that  does  not  assume  excessive  proportions;  a  manu¬ 
facturer  of  surgical  appliances,  for  example,  can  readily  obtain  and  utilize 
a  practically  complete  list  of  possible  customers.  For  the  great  mass  of 
goods  sold  at  retail,  however,  and  for  general  supplies  sold  to  manufacturers, 
the  market  is  of  a  different  type  and  potential  demand  is  much  less  easily 
estimated. 

In  undertaking  an  analysis  of  the  market  for  an  article  which  is  sold 
over  a  wide  territory  and  for  which  a  market  index  can  be  selected  only 
with  difficulty,  too  much  attention  may  be  given  to  wealth  statistics,  which 
are  assumed  to  indicate  incomes  received  by  consumers.  Wealth  statistics, 
as  a  rule,  have  little  significance  in  market  analysis.  In  the  first  place, 
there  are  no  reliable  wealth  statistics,  and,  in  the  second  place,  even  if 
such  statistics  were  available,  they  would  give  slight  clue  to  the  probable 
demand  for  any  particular  article.  Wealth  statistics  are  published,  to  be 
sure,  by  the  United  States  government,  but  they  are  rough  approximations. 

Wealth  statistics  are  commonly  reduced  to  a  per  capita  basis,  but  a 
per  capita  wealth  figure  is  of  little  worth  for  any  purpose,  for  it  does  not 
show  the  distribution  of  the  wealth.  It  makes  a  vast  difference  to  manu¬ 
facturers  looking  for  prospective  markets  whether  the  wealth  in  any  district 
is  fairly  evenly  distributed  among  the  consumers  or  concentrated  largely 
in  the  hands  of  a  few  very  rich  persons;  the  quantity  of  any  commodity 
purchased  by  an  individual  consumer  seldom  varies  in  direct  proportion  to 
his  wealth  or  income^ 

Finally,  even  if  the  wealth  figures  were  available  in  such  form  that  they 
could  be  relied  upon  and  the  distribution  of  the  wealth  among  the  popula¬ 
tion  ascertained,  the  figures  would  not  accurately  indicate  market  potentiali¬ 
ties.  Not  only  are  wealth  statistics  inadequate  indices  of  incomes,  but 
different  classes  of  people  engaged  in  different  occupations  and  living  under 
different  conditions  do  not  expend  their  incomes  in  the  same  way,  even  if 
those  incomes  are  approximately  equal. 


14 


RISK  AND  RISK-BEARING 


Average  wages  are  another  set  of  statistics  occasionally  referred  to  as 
furnishing  an  index  of  potential  demand.  The  United  States  Bureau  of 
the  Census  publishes  average  wage  statistics,  and  similar  figures  may  be 
obtained  from  other  sources.  An  average  wage,  however,  for  all  the  persons 
engaged  in  manufacturing  in  Massachusetts,  for  example,  includes  the 
wages  of  numerous  highly  skilled  workmen  and  also  the  wages  of  unskilled 
men,  women,  and  children.  The  average  is  not  representative  and  does 
not  indicate  that  Massachusetts  is  necessarily  a  poorer  potential  market 
for  any  manufacturer  than  some  other  states  where  the  average  wages  may 
be  higher. 

Per  capita  consumption  figures  for  large  groups  of  commodities,  such 
as  clothing  or  foodstuffs,  are  finding  their  way  into  some  advertising  pub¬ 
lications,  as  affording  a  guide  to  potential  markets.  The  only  per  capita 
consumption  figures  which  are  worthy  of  consideration  are  those  for  such 
articles  as  coffee  or  sugar,  where  fairly  accurate  records  of  importation  and 
domestic  production  are  maintained.  The  census  figures  for  the  value  of 
the  product  of  the  various  manufacturing  industries  are  too  inaccurate,  in 
the  form  in  which  they  are  presented,  to  be  acceptable  as  a  basis  for  estimates 
of  per  capita  consumption,  and  there  is  too  great  uncertainty  as  to  the 
amounts  added  to  the  manufacturers’  selling  prices  in  the  course  of  the 
marketing  processes  to  warrant  placing  any  reliance  upon  estimates  of 
total  retail  selling  value  or  total  amounts  paid  by  consumers  for  these 
products.  These  per  capita  consumption  figures,  moreover,  are  gross 
figures  including  many  grades  and  qualities,  some  of  which  are  virtually 
non-competing.  Such  statistics  are  of  little  aid  in  making  a  careful  market 
analysis. 

Instead  of  attempting  to  use  statistics  for  wealth,  income,  or  per  capita 
consumption,  the  first  task  in  undertaking  a  statistical  analysis  of  a  market 
is  properly  to  determine  just  what  class  or  classes  of  consumers  constitute 
the  potential  market  and,  if  there  are  varying  degrees  of  demand,  what 
demand  may  be  expected  from  each  class.  For  this,  personal  investigation 
or  inquiry  may  be  necessary.  The  next  step  is  to  ascertain  the  number 
of  consumers  of  each  class  in  each  sales  district.  From  these  two  sets  of 
statistics  the  total  potential  demand  for  each  district  under  normal  condi¬ 
tions  can  be  estimated. 

These  figures  for  estimated  potential  demand,  when  compared  with  past 
sales  records,  show  in  which  districts  the  best  opportunities  exist  for  sales 
development  and  serve  as  a  basis  for  establishing  quotas  for  salesmen. 
Ordinarily  the  comparison  of  sales  records  with  estimated  potential  demand 
shows  that  the  degree  of  saturation  is  not  uniform  in  all  markets.  It  is 
usually  found  upon  investigation  that  a  higher  percentage  of  potential 
demand  has  been  realized  in  some  markets  than  in  others,  thus  indicating 
the  direction  in  which  expansion  may  most  readily  take  place. 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


IS 


Another  factor  to  which  attention  may  be  given  in  analyzing  a  market 
for  some  products  is  the  percentage  of  distribution — that  is,  the  percentage 
of  the  total  number  of  possible  retail  outlets  in  which  the  goods  in  question 
are  sold.  A  manufacturer  of  a  food  product  sold  in  retail  grocery  stores 
generally  wishes  to  induce  as  large  a  number  of  grocers  as  possible  in  each 
district  to  carry  his  product.  If  75  per  cent  of  the  retail  grocery  stores  are 
selling  the  article,  he  considers  that  he  has  75  per  cent  distribution,  without 
reference,  of  course,  to  the  relative  volume  of  trade  of  the  retailers. 

In  establishing  sales  quotas,  allowances  must  be  made  not  only  for 
differences  in  degree  of  saturation  and  percentages  of  distribution  but  also 
for  differences  in  general  business  conditions.  From  season  to  season  general 
business  conditions  fluctuate  in  each  district.  A  poor  cotton  crop  may  cut 
down  the  normal  demand  in  the  cotton  states  while  a  good  grain  crop  in 
the  same  year  may  cause  business  to  be  exceptionally  brisk  in  the  wheat 
district.  Hence  the  statistical  indices  of  business  conditions  in  each 
district  must  be  taken  into  account  in  comparing  salesmen’s  records  with 
established  quotas. 

TIME  AND  MOTION  STUDY1 

According  to  statements  made  by  scientific  managers,  the  process  of 
analysis,  or  time  and  motion  study,  in  the  larger  sense,  should  where 
possible  begin  with  the  determination  of  a  site  for  manufacture.  The 
really  scientific  manager,  starting  out  de  novo,  will  consider  all  available 
sites  with  reference  to  the  time  and  motion  expenditure,  determined 
by  actual  experiment,  necessary  in  securing  an  adequate  supply  of  proper 
materials,  in  the  going  to  and  from  the  shop  of  the  numbers  of  the  different 
classes  of  workmen  needed  or  likely  to  be  needed,  in  the  shipment  and 
marketing  of  the  product,  etc.  Having  in  mind  the  character  of  the 
productive  process,  and  the  most  efficient  productive  arrangements  possible, 
he  will  then,  with  regard  to  the  greatest  possible  saving  of  waste  time  and 
motion,  work  out  with  the  utmost  care  and  with  reference  to  future  expansion 
the  plans  for  the  construction  of  his  plant.  This  will  involve  a  most  careful 
study  of  all  the  general  internal  arrangements  and  processes,  the  most 
efficient  methods  of  planning  the  work  to  be  done  and  of  routing  it  through 
the  shop  so  that  there  may  be  no  delay  in  transmitting  orders,  no  waste 
carriage  of  materials  and  partly  finished  products,  no  lost  time  in  the 
assembly  room  waiting  for  delayed  parts.  With  the  same  ends  in  view, 
and  in  the  same  manner,  he  will  also  determine  the  most  effective  placement 
of  machinery,  the  storage  of  tools  and  materials,  and  the  location  of  the 
various  elements  of  the  office  force. 

The  shop  constructed  and  the  machinery  installed,  he  will  apply  time 
and  motion  study  in  an  endless  series  of  experimental  tests  to  determine 

Adapted  by  permission  from  R.  F.  Hoxie,  “Scientific  Management  and 
Labor  Welfare,”  Journal  of  Political  Economy,  XXIV  (1916),  833-43. 


i6 


RISK  AND  RISK-BEARING 


what  possible  improvements  can  be  made  in  machinery  and  its  operation, 
and  in  the  tools,  fixtures,  materials,  and  specific  processes  of  "work.  The 
best  feed  and  speed  for  each  machine,  with  reference  to  the  different  grades 
of  materials,  will  then  be  established.  The  different  jobs  or  processes  will 
be  analyzed  and  re-analyzed,  and  their  elements  experimentally  combined 
and  recombined,  the  tools  and  fixtures  changed  and  rearranged,  and  all 
these  variations  timed  and  retimed  in  an  effort  to  discover  the  most  efficient 
productive  combinations  and  methods. 

This  time  and  motion  study  analysis  will  extend,  it  is  thus  claimed,  to 
every  feature  and  all  organic  relationships  of  the  mechanical  process  of 
production.  But  it  will  not  stop  there.  It  will  be  extended  to  cover  the 
managerial  functions  and  the  office  work.  The  duties  of  the  managers, 
superintendents,  and  especially  of  the  shop  foremen  will  be  analytically 
studied  and  reorganized.  The  methods  of  storage  and  delivery  of  tools  and 
materials,  the  dispatching  of  orders  from  the  office  to  the  shop,  the  purchas¬ 
ing  of  materials,  the  marketing  of  products,  and  all  the  methods  of  account¬ 
ing  will  likewise  be  subjected  to  time  and  motion  study,  in  this  larger  sense, 

with  a  view  to  discovering  the  most  efficient  means  and  methods . 

It  will  endeavor  to  discover  by  repeated  analysis  and  experimental  timing 
the  best  character,  combination,  and  arrangement  of  tools,  materials, 
machinery,  and  workmen,  the  most  efficient  and  convenient  lighting,  heat¬ 
ing,  and  seating  arrangements  for  the  workmen,  the  proper  period  for  con¬ 
tinuous  operation  by  them,  considering  the  element  of  fatigue,  the  rest 
periods  needed,  their  most  efficient  character,  combination,  and  sequence 
of  motions,  etc.  Moreover,  these  particular  job  experiments  will  not  be 
confined  to  one  man,  or  to  a  few  of  those  who  are  to  accomplish  the  task. 
Many  men  will  be  timed  with  the  idea  of  discovering,  not  the  fastest  speed 
of  the  fastest  man,  but  the  normal  speed  which  the  group  can  continuously 
maintain.  If  necessary,  hundreds  and  perhaps  thousands  of  time  and 
motion  studies  will  be  made  to  determine  this  before  the  task  is  set  and  the 
rate  established.  And  whenever  a  new  or  better  method  or  combination 
has  been  discovered  by  the  time  and  motion  analysis,  which  is  supposed  to 
continue  even  after  the  task  is  set,  the  whole  process  of  careful  and  extended 
timing  for  task-setting  will  be  repeated,  and  new  tasks  and  rates  established 
reasonably  conformable  to  the  new  conditions. 

Finally,  as  an  integral  part  of  this  broader  time  and  motion  study,  all 
the  results  secured  by  it  will  be  continuously  and  systematically  filed  as  a 
permanent  asset  and  guide  to  future  action.  Thus  conceived,  time  and 
motion  study  appears  to  be  considered  a  method  of  analysis  applicable  to 
practically  every  feature  of  the  productive  and  distributive  process,  con¬ 
sidered  apart  from  its  purely  financial  aspects,  a  process  of  analysis  applied 
continuously  throughout  the  life  of  the  establishment.  And  the  scientific 
management  based  upon  it  is  conceived  to  be  a  perpetual  attempt  to  dis¬ 
cover  and  put  into  operation  the  new  and  continuously  developing  technical, 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


17 


organic,  and  human  arrangements,  methods,  and  relationships  constantly 
revealed  by  it  to  be  more  efficient  and  more  equitable.  That  this  broader 
conception  of  time  and  motion  study  as  the  essential  basis  of  scientific 
managements  exists  not  as  a  mere  dream,  but  as  a  practical  ideal  striven 
for  with  the  confident  hope  of  realization,  the  writer  can  attest  from  his 
experiences  in  the  best  class  of  scientific-management  shops. 

Although  the  drift  in  the  direction  of  scientific  method  is  clear,  the 
extent  to  which  the  standards  of  exact  science  can  be  maintained 
varies  greatly  with  the  character  of  the  facts  to  be  handled.  In  the 
physical  sciences  no  solution  is  accepted  which  does  not  square  with 
all  the  known  facts,  and  if  not  all  the  relevant  facts  are  known,  judg¬ 
ment  must  be  suspended  till  they  can  be  secured  by  observation  or 
by  experiment.  In  this  realm,  no  truly  scientific  judgment  rests  on 
estimates.  This  is  less  true  of  the  biological  sciences,  and  still  less  of 
the  social  sciences.  In  psychology,  philology,  ethics,  sociology,  educa¬ 
tion,  economics,  the  phenomena  are  so  complex,  the  objects  of  study 
are  so  heterogeneous,  and  the  mass  of  relevant  data  is  so  enormous  that 
resort  must  often  be  had  to  samples  instead  of  complete  data,  esti¬ 
mates  frequently  take  the  place  of  measurements,  and  evidence  which 
falls  far  short  of  meeting  the  standards  of  the  exact  sciences  is  ne¬ 
cessarily  accepted  as  a  basis  for  generalization.  Consequently 
conclusions  must  be  less  final.  This  is  true  partly  because  of  con¬ 
siderations  of  time  and  partly  because  of  considerations  of  cost.1 
The  student  of  astronomy  can  afford  to  wait  for  years  for  the  reappear¬ 
ance  of  a  comet  or  of  a  total  eclipse  to  confirm  or  disprove  his 
hypothesis,  the  physicist  can  spend  enough  money  on  a  single  experi¬ 
ment  to  make  sure  the  conclusions  are  right,  knowing  that  if  the 
measurements  are  exact  the  experiment  need  not  be  repeated,  but  the 
educator,  the  military  scientist,  or  the  anthropologist  cannot  as  a 
rule  test  his  theories  completely  in  the  laboratory.  He  cannot  even 
expend  the  funds  necessary  to  observe  the  world-wide  variations  of 
the  phenomenon  he  is  studying.  And  yet  he  cannot,  if  his  science  is 
to  have  any  practical  application,  defer  judgment  till  the  evolution  ot 
society  has  confirmed  or  disproved  his  views.  Hence  he  must  speak 
in  terms  of  preponderance  of  evidence,  of  typical  results,  of  tendencies, 
and  of  probable  results  from  given  lines  of  conduct. 

1  It  is  perhaps  worth  noting  that  time  and  cost  are  not  entirely  separable 
elements.  Often  they  depend  on  one  another,  that  is,  it  is  possible  to  shorten  the 
time  of  an  investigation  if  cost  can  be  disregarded,  or  to  avoid  the  cost  if  one  can 
wait  long  enough  for  the  facts  to  become  clear. 


i8 


RISK  AND  RISK-BEARING 


The  same  contrast  appears  in  the  attempt  to  apply  the  scientific 
method  to  the  solution  of  business  problems  which  we  have  seen  in 
its  application  to  problems  of  thought  and  of  knowledge.  In  dealing 
with  certain  types  of  data,  highly  exact  measurements  are  possible, 
and  the  results  repeat  themselves  with  accuracy.  Questions  of  the 
technique  of  machine  industry  are  of  this  type,  so  long  as  comparisons 
of  prices  (of  cost  goods  and  output)  are  excluded,  and  even  these  over 
short  periods  of  time  are  susceptible  of  very  reliable  estimation.  It 
is  in  this  field,  therefore,  that  scientific  management  has  made  the 
most  rapid  strides.  The  value  of  accuracy  and  of  scientific  planning 
is  no  longer  a  question;  the  engineer  has  won  his  place.  On  the 
other  hand,  as  was  noted  in  chapter  i,  in  agricultural  production  the 
incalculable  element  of  weather  makes  it  impossible  to  predict  results 
with  the  same  accuracy,  and  in  marketing,  finance,  and  labor  admin¬ 
istration  uncertainties  abound,  some  due  merely  to  the  undeveloped 
state  of  the  science  of  business  research,  others  impossible  to  avoid. 

There  are  very  definite  limits  to  the  extent  to  which  individual  busi¬ 
nesses  find  it  to  their  advantages  to  eliminate  risk  either  through  research 
or  through  protective  devices.  The  determining  consideration  is  one 
of  cost,  and  there  are  many  fields  in  which  it  remains  true  that  it  is 
cheaper  to  run  risks  than  to  avoid  them.  Cost  of  elimination  of 
risk,  moreover,  is  often  in  the  nature  of  a  fixed  charge.  One  night 
watchman,  for  example,  can  keep  guard  over  numerous  buildings 
almost  as  well  as  over  one.  One  lighthouse  warns  thousands  of  vessels. 
Once  the  research  necessary  to  establish  a  new  truth  has  been  com¬ 
pleted  it  costs  little  to  impart  the  results  to  many  businesses  and 
perpetuate  it  for  future  generations.  But  the  original  costs  of  obtain¬ 
ing  the  information  may  involve  a  large  investment  with  a  high  degree 
of  risk  that  nothing  useful  will  be  learned.  The  larger  the  volume  of 
business,  the  more  likely  is  this  fixed  charge  to  be  a  good  investment; 
hence  a  strong  tendency  shows  itself,  other  things  being  equal,  for 
risky  enterprises  to  be  carried  by  large-scale  methods. 

The  same  advantage  may  be  gained  by  either  of  two  other 
methods  —  co-operation  and  specialization. 

In  the  co-operative  method  the  cost  of  research  or  protection  is  divided 
directly  among  a  large  number  of  business  units.  This  method  of 
reducing  risk  is  well  illustrated  by  many  of  the  activities  of  govern¬ 
ment.  Weather-forecasting  has  reduced  immensely  the  risks  of  loss 
and  damage  to  property  on  account  of  frost  and  flood.  No  single 
business  could  afford  to  maintain  a  weather-forecasting  service  of  the 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


19 


scope  of  that  provided  by  the  government,  yet  when  the  cost  of  this 
service  is  spread  over  all  the  lines  of  business  which  profit  by  it,  it 
makes  only  a  trifling  addition  to  the  burden  of  taxation.  Research 
undertaken  by  the  Department  of  Agriculture,  the  Department  of 
Commerce,  consular  bureaus,  and  the  Geological  Survey  has  resulted 
in  large  additions  to  our  store  of  exact  knowledge  in  fields  where  a 
few  years  ago  production  was  prevented  or  made  hazardous  by  a  lack 
of  sufficient  facts  on  which  to  base  a  valid  judgment.  In  like  manner 
government  may  be  shown  to  be  our  most  important  co-operative 
device  for  eliminating  risk  through  prevention  of  harmful  events.  The 
maintenance  of  fire  departments  and  of  lighthouses  and  many  other 
phases  of  government  activity  are  merely  co-operative  methods  of 
eliminating  the  risks  of  production  through  activities  which  would  be 
far  too  costly  for  single  businesses,  but  which  are  very  economica 
when  their  cost  is  divided  among  all  who  benefit  from  them. 

Other  co-operative  devices  besides  government  may  be  used  in 
the  same  way.  Chambers  of  commerce  maintain  bureaus  of  exchange 
of  credit  information  to  lessen  the  risk  of  bad  debts.  In  small  com¬ 
munities  they  often  contribute  to  the  support  of  night  watchmen  to 
supplement  the  protection  afforded  by  the  city  police.  Trade  associa¬ 
tions  reduce  risk  by  the  maintenance  of  research  organizations.  This 
is  but  a  beginning  of  a  very  long  list. 

A  second  characteristic  modern  method  of  spreading  the  cost  of 
research  over  a  large  number  of  business  units  is  the  development  of 
specialists  who  furnish  the  service  for  pay.  This  method  is  illustrated 
by  such  diverse  enterprises  as  clipping  bureaus,  advertising  agencies, 
investors’  service  bureaus.  A  very  recent  development  of  this  sort 
is  the  specialized  labor  service  bureau  whose  chief  business  is  the 
collection  of  data  for  trade-union  use  in  labor  disputes. 

3.  Elimination  of  risks  by  combination  increases  in  importance  with 
the  development  of  large-scale  enterprise. — By  combination  of  risks  is 
meant  a  grouping  of  similar  items  in  such  a  way  that  we  can  tell  more 
about  the  group  than  we  can  about  the  items  which  compose  it. 
Elimination  of  risk  by  combination  is  the  application  of  the  so-called 
law  of  large  numbers.  It  is  often  the  case  that  we  have  a  high  degree 
of  certainty  about  a  group  of  data  while  at  the  same  time  we  are  in 
complete  ignorance  about  the  particular  items  which  make  up  the 
group.  Thus  we  may  be  quite  sure  that  we  can  predict  within  30 
per  cent  the  amount  of  rainfall  which  will  occur  in  a  given  region  in 
the  next  year,  while  if  we  try  to  predict  the  precipitation  for  any 


20 


RISK  AND  RISK-BEARING 


particular  week,  it  is  more  likely  than  not  that  the  actual  result  will 
be  either  less  than  io  per  cent  or  more  than  1,000  per  cent  of  our  esti¬ 
mate.  So  with  death  rates,  marriages,  enrolments  in  colleges,  deser¬ 
tions  from  the  army,  accidents  due  to  fireworks,  and  thousands  of 
other  contingencies.  A  single  event  defies  prediction,  but  the  mass 
remains  always  practically  the  same  or  varies  in  ways  which  we  can 
predict.  It  is  obvious  that  any  device  by  which  we  can  base  our 
business  decisions  on  the  average  which  we  can  predict,  instead  of  on 
the  single  event,  which  is  uncertain,  means  the  elimination  of  risk. 
The  larger  the  number  of  cases  observed  the  less  is  the  deviation  of 
results  from  those  which  a  priori  were  most  probable.  (Cf.  note  i,p.  27.) 

In  the  following  selection  Professor  Ross  elaborates  a  number  of 
applications  of  the  principle  of  combination  of  risks: 

The  uncertainty  as  regards  the  yield  of  product  sets  up  a  current  of 
amalgamation  that  favors  large-scale  industry.  In  almost  any  line  of  pro¬ 
duction  minor  fluctuations  are  constantly  occurring  in  the  different  parts 
of  a  business.  As,  however,  these  succumb  to  an  average  within  the  single 
enterprise,  they  inspire  no  uncertainty  and  are  not  disturbing  factors. 
The  larger  the  enterprise  the  more  do  the  variations  incident  to  its  branch 
of  production  reduce  to  an  average  and  disappear,  the  fewer  are  the  uncom¬ 
prehended  species  of  variation.  For  instance,  to  the  owner  of  a  cow  the 
loss  at  calving  time  is  uncertain,  while  to  the  owner  of  a  great  herd  this  loss 
appears  as  a  regular  percentage  that  can  be  computed  and  allowed  for. 
Even  to  the  rancher  the  loss  by  stampede  is  uncertain,  but  to  a  great  cattle 
syndicate  with  many  herds,  the  loss  from  this  source  can  be  roughly  esti¬ 
mated  in  advance.  Again,  in  a  small  refinery  the  possibility  of  over-doing 
a  batch  of  oil  or  sugar  may  be  a  source  of  serious  uncertainty,  while  in  a 
large  refinery  the  law  of  the  average  prevails. 

But  with  a  rapid  growth  in  the  size  of  the  business  unit,  the  great 
fortunes  prove  too  few  to  handle  the  big  enterprises.  Hence  the  joint-stock 
corporation  is  invoked  to  supply  masses  of  capital  without  calling  on  the 
rich  man.  Albeit  the  stimulus  to  corporate  enterprise  has  been  ascribed 
to  the  growth  of  great  industry,  no  small  measure  of  its  success  has  been  due 
to  its  fitness  for  uncertain  undertakings.  By  owning  stock  in  a  dozen  differ¬ 
ent  corporations  and  sharing  in  a  dozen  undertakings,  one  is  exposed  to 
twelve  times  as  many  variations,  but  each  disturbs  only  one-twelfth  as 
much  as  when  one  is  proprietor  of  a  single  enterprise.  Some  of  the  numerous 
variations  will  cancel  each  other,  and  the  rest  will  locate  their  effects  at  the 
margin  of  one’s  fortune,  where  the  subjective  value  of  equal  losses  and 
gains  is  nearly  the  same. 

The  corporate  form,  therefore,  is  at  its  best  a  mutual  insurance  scheme, 
whereby  the  losses  and  gains  due  to  variations  are  first  pooled,  and  then 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


21 


shared  equitably  among  a  large  number.  By  thus  enlarging  the  bearing 
and  absorbing  surface,  by  creating  solidarity  through  the  interlacing  of 
many  private  interests,  the  difference  between  the  variable  and  the  uniform 
type  of  production  is  minimized.  While  there  is  a  corporate  drift  all  over 
the  field  of  business,  we  find  it  most  pronounced  in  speculative  branches, 
such  as  mining,  boring  for  oil  or  gas,  electric  enterprise,  building  and 
improvement  undertakings,  the  theatre  business,  and  the  introduction  of 
new  devices,  machines,  utensils,  toys,  foods,  fibers,  fuels,  etc.1 

4.  Risks  may  be  lessened  by  the  maintenance  of  reserves,  i.e.,  the 
withholding  of  resources  from  use  to  have  them  in  readiness  for  a 
contingency  which  may  or  may  not  appear.  Even  in  seasons  of  most 
active  business,  the  existence  of  risk  prevents  the  employment  of  our 
resources  to  100  per  cent  capacity.  Some  items  may  be  utilized  to 
capacity  or  beyond  proper  capacity,  but  in  many  departments  there 
are  always  some  reserves  of  capital  not  actively  employed.  Thus  the 
manager  of  a  bank,  in  addition  to  the  funds  he  expects  to  need  from 
day  to  day,  carries  in  his  vaults  a  sum  of  fdle  money  which  he  probably 
will  not  need,  but  which  at  some  time  he  may  need  very  badly.  The 
grocer  carries  a  little  bigger  stock  than  he  will  probably  need  before 
he  can  secure  another  shipment.  Financial  managers  refuse  to  pay 
out  in  dividends  the  entire  earnings  of  their  firms,  or  even  the  full 
amount  which  can  apparently  be  spared.  Manufacturers  carry  extra 
stocks  of  raw  materials  and  of  repair  parts.  Such  reserves  are  not 
entirely  due  to  the  risk.  They  may  be  accounted  for  by  economies 
in  manufacture  or  transportation  of  large  units,  but  in  large  part  they 
are  necessitated  by  the  presence  of  risk. 

The  loss  of  production  due  to  the  idleness  of  the  capital  reserve 
cannot  properly  be  called  a  waste.  Its  maintenance  is  a  cost — the  cost 
of  uncertainty.  Whether  it  is  a  social  waste  depends  on  the  question 
whether  the  uncertainty  can  be  removed  at  a  cost  less  than  the  loss 
of  production  from  the  maintenance  of  the  reserve.  In  large  part, 
the  uncertainty  is  of  course  quite  beyond  our  powers  to  remove,  and 
the  maintenance  of  the  reserve  may  be  the  most  economical  way  to 
deal  with  it.  So  long  as  this  is  true,  the  cost  of  maintaining  reserves 
is  no  more  a  “waste”  than  is  the  wear  and  tear  on  machinery  or  the 
cost  of  raw  materials  used  up. 

Professor  Pigou  has  pointed  out  the  way  in  which  the  develop¬ 
ment  of  a  more  coherent  social  organization  has  made  possible  a  more 

1  Adapted  by  permission  from  E.  A.  Ross,  “Uncertainty  as  a  Factor  in  Pro¬ 
duction,”  in  Annals  of  the  American  Academy  of  Political  and  Social  Science ,  VIII 
(1896),  115-19. 


22 


RISK  AND  RISK-BEARING 


effective  combination  of  risks  and  thereby  rendered  the  maintenance 
of  reserves  less  necessary: 

The  development  in  the  means  of  communication  facilitates  the  com¬ 
bination  of  uncertainties  in  one  very  simple  way.  It  puts  investors  into 
contact  with  a  greater  number  of  different  openings  than  were  formerly 
available.  This  effect,  though  of  great  importance,  is  so  obvious  and  direct 
that  no  comment  upon  it  is  required.  There  is,  however,  a  more  subtle  way 
in  which  the  development  in  the  means  of  communication  works.  Dr. 
Cassel  has  observed  that  industrial  firms  have,  in  recent  times,  been  lessen¬ 
ing  the  quantity  of  stock  that  they  carry  in  store,  waiting  to  be  worked  up 
relatively  to  their  total  business.  The  improvement  in  this  respect  applies 
all  round.  As  regards  production,  “  there  is,  in  the  best-organized  industries, 
very  little  in  the  way  of  material  lying  idle  between  two  different  acts  of 
production,  even  if  these  acts  have  to  be  carried  out  in  different  factories, 
perhaps  at  great  distances  from  each  other.  A  modern  iron-works  has  no 
large  stock  either  of  raw  materials  or  of  their  product,  yet  there  is  a  con¬ 
tinuous  stream  of  ore  and  coal  entering,  and  of  iron  being  turned  out  of  it.” 
In  like  manner,  factories  are  coming  to  keep  a  smaller  amount  of  capital 
locked  up  in  the  form  of  reserve  machines  not  ordinarily  in  use.  The  same 
tendency  is  apparent  in  retail  trading.  The  ratio  of  the  average  amount 
of  stock  kept  to  the  aggregate  annual  turn-over  is  smaller  than  it  used  to  be. 

Now,  prima  facie,  this  change  of  custom  would  seem  to  be  of  little 
significance.  After  all,  a  reduction  in  the  amount  of  finished  goods  held  by 
retailers,  of  reserve  machinery  held  by  manufacturers,  and  so  on,  does  not 
necessarily  imply  a  reduction  in  the  aggregate  amount  of  these  things  held 
by  the  whole  body  of  industrials.  On  the  contrary,  we  are  naturally  inclined 
to  suggest  that  the  wholesaler  and  the  machine-maker  must  increase  their 
stocks  pari  passu  with  the  decrease  in  the  stocks  of  their  clients.  As  a 
matter  of  fact,  however,  this  suggestion  is  incorrect.  The  reason  is  that 
the  wholesaler  and  the  machine-maker  represent  points  at  which  uncertain¬ 
ties  can  be  combined.  The  development  of  the  means  of  communication, 
therefore,  in  so  far  as  it  directly  transfers  to  them  the  task  of  bearing  uncer¬ 
tainty,  indirectly  lessens  the  amount  of  uncertainty  that  needs  to  be  borne. 
Uncertainty-bearing,  in  short,  is  rendered  more  efficient.1 

Another  writer  has  shown  that  combination  of  risks  operates  in 
exactly  the  same  way  to  reduce  the  necessary  social  reserves  of 
unemployed  labor: 

The  irreducible  minimum  of  unemployment  does  not  appear  only  in 
the  general  percentage  for  all  trades  taken  together,  it  is  shown  also  by  each 
trade  or  group  of  trades  taken  separately . 

’  A  C.  Pigou,  Wealth  and  Welfare,  pp.  ioo,  ioi.  (The  Macmillan  Co.) 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


2  3 


It  holds  true  not  of  decaying  industries  but  of  those  on  which  the 
development  of  the  nation’s  prosperity  has  been  based.  For  each  group, 
indeed,  taken  as  a  whole,  there  appears  to  be  much  the  same  irreducible 
minimum  below  which  the  year’s  unemployment  percentage  never  falls. 
Depression  of  trade  is  marked  by  very  varying  maxima.  In  the  best  years 
all  the  groups  alike  tend  to  have  about  two  per  cent,  unemployed.  An 
excess  of  the  supply  of  labour  over  the  demand  appears  to  be  a  normal 
condition  in  the  skilled  and  organized  trades. 

Suppose  that  ten  centres  of  casual  employment — say  ten  similar 
wharves — each  employ  from  50  to  100  men  on  any  one  day,  so  that  each 
considered  separately  requires  a  regular  staff  of  50  and  a  “reserve”  of  50 
more.  In  so  far  as  the  variations  of  work  depend  upon  general  causes, 
affecting  all  the  wharves  simultaneously  and  similarly,  the  busy  and  slack 
times  respectively  will  tend  to  coincide  and  the  variations  in  the  total  work 
to  reproduce  proportionately  those  of  each  separate  wharf.  In  so  far, 
however,  as  the  variations  at  different  wharves  are  unconnected,  they  will, 
in  the  total  of  men  required  at  all  the  ten  from  day  to  day,  tend  to  neutralise 
one  another,  because  a  busy  time  at  some  wharves  will  coincide  with  a 
slack  time  at  others.  Suppose  that  in  fact  the  numbers  employed  at  the 
whole  ten  from  day  to  day  range  from  a  minimum  of  700  to  a  maximum  of 
800.  These  daily  numbers,  whatever  they  are,  will  give  the  numbers  of 
“regular”  and  “reserve”  labourers  who  may  theoretically  find  work  at  the 
whole  ten  wharves  taken  together.  They  must  be  taken  as  unalterable, 
determined  solely  by  the  necessary  irregularities  of  trade  and  tide.  They 
would  presumably  be  the  actual  numbers  employed  supposing  all  the  ten 
were  amalgamated  into  a  single  wharf  having  the  same  mass  and  flow  of 
custom.  But  so  long  as  the  wharves  remain  distinct,  the  number  of  indi¬ 
viduals  who  will  practically  be  required  to  do  the  same  work  is  affected  also 
by  quite  a  different  set  of  considerations.  It  is  clear  that  if  each  separate 
wharf  forms  an  absolutely  distinct  labour  market  so  that  no  man  works 
at  more,  than  one,  then,  however  the  variations  of  business  neutralise  one 
another,  the  number  of  individuals  required  to  do  the  work  will  be  100  for 
each  wharf  or  1,000  in  all.  It  is  clear,  on  the  other  hand,  that  if  the  whole 
ten  form  a  single  labour  market  within  which  labour  is  absolutely  fluid, 
then  the  full  number  of  individuals  required  will  coincide  with  the  maximum 
of  800  employed  on  any  one  day.  The  total  number  of  men  practically 
required  to  do  the  work  without  delay  (and  by  consequence  the  number  of 
reserve  labourers)  is,  in  fact,  increased  by  every  barrier  to  free  movement 
from  one  wharf  to  another,  and  can  be  correspondingly  decreased  by  every¬ 
thing  tending  to  the  organisation  of  the  whole  ten  into  a  single  labour 
market. 

The  greatest  barrier  to  free  movement  in  any  area  is  ignorance  among 
the  men  as  to  the  demand  for  labour  in  different  directions;  every  means 
taken  to  remove  this  ignorance  enables  the  work  of  any  area  to  be  done  with 


24 


RISK  AND  RISK-BEARING 


a  smaller  reserve  of  labour.  But  the  general  distribution  of  the  most 
accurate  information  as  to  the  amount  of  work  at  each  centre  is  only  a 
first  step.  Even  if  every  man  knows  exactly  how  many  men  will  be  wanted 
next  day  at  each  wharf,  this  will  not  of  itself  (i.e.,  unless  each  knows  also 
exactly  how  his  fellows  will  act)  prevent  too  many  individuals  from  applying 
at  one  wharf  and  (perhaps)  too  few  at  another.  If  it  is  desired  to  do  the  work 
with  the  smallest  possible  reserve  of  labour,  some  means  must  be  adopted 
for  directing  the  right  number  of  specified  individuals  to  each  wharf  from 
some  one  centre  or  exchange. 

The  foregoing  arguments  may  now  be  summarised.  For  the  work  of 
a  group  of  casual  employers  a  certain  theoretically  determinable  number  of 
men  may  be  regarded  as  necessary;  the  number  will  be  fixed  by  conditions 
of  trade  which  must  be  taken  for  the  present  as  unalterable.  And,  in  so 
far  as  these  trade  conditions  involve  rapid  and  irregular  variations  of  work 
within  fairly  definable  limits,  a  part  of  this  total  number  will  have  the 
character  of  an  inevitable  reserve  of  partially  employed  labour.  But  the 
actual  number  of  men  by  whom  the  work  is  done,  and  its  relation  to  the 
theoretically  necessary  number,  will  be  affected  also  by  another  set  of  con¬ 
siderations,  quite  unconnected  with  the  total  volume  of  work  or  the  unalter¬ 
able  conditions  of  trade.  In  the  first  place,  every  hindrance  to  the  perfect 
fluidity  of  labour  from  centre  to  centre  will  swell  the  actual  number  of  indi¬ 
viduals  doing  the  work  by  an  amount  representing  the  degree  of  friction. 
To  return  to  the  numerical  instance,  the  work  of  ten  wharves,  which,  if 
they  had  become  for  purposes  of  employment  one  wharf,  might  have  been 
done  by  800  men,  would  with  a  certain  degree  of  friction,  require  the  services 
of  900.  In  that  case  there  would,  even  when  the  wharves,  as  a  whole,  were 
busiest,  be  at  least  100  men  out  of  work. 

Those  men  who  will  in  practice  be  added  to  the  theoretical  maximum 
for  any  area  by  friction  between  its  separate  centres,  though  the  product  of 
disorganisation  are  true  reserve  of  labour  without  which,  given  that  degree 
of  disorganisation  and  friction,  the  industry  could  not  be  carried  on  1 

It  will  be  noted  in  the  foregoing  argument  that  the  problem  is  not 
solved  by  distributing  accurate  information  as  to  the  amount  of  work. 
What  each  will  do  is  for  the  individual  to  determine.  If  one  is  to  do 
this  with  scientific  accuracy,  it  is  necessary  for  him  to  know  what 
every  other  laborer  is  going  to  do  and,  of  course,  it  is  equally  important 
for  everyr  other  laborer  to  know  what  the  first  laborer  is  going  to  do. 
If  each  man’s  decisions  depend  upon  other  men’s  conduct  it  is 
obviously  impossible  to  eliminate  a  large  amount  of  uncertainty  by 
any  conceivable  system  of  information.  The  only  way  to  eliminate 

1  Adapted  by  permission  from  W.  H.  Beveridge,  Unemployment ,  pp.  68-81. 
(Longmans,  Green  &  Co.,  New  York,  1910.) 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


25 


this  element  of  uncertainty  is  to  establish  some  central  agency  to 
apportion  the  labor  in  accordance  with  some  agreed  standard  of 
proper  distribution. 

Exactly  the  same  analysis  applies  to  every  other  form  of  competi¬ 
tion.  So  long  as  we  actually  have  competition,  one  large  element  of 
uncertainty  can  never  be  eliminated.  No  matter  how  accurate  the 
business  man’s  information  as  to  the  prospects  in  a  new  field,  his 
decision  to  enter  that  field  involves  a  large  element  of  risk,  unless  he 
knows  how  many  other  people  are  contemplating  the  same  oppor¬ 
tunity  and  how  many  of  them  will  finally  decide  to  enter  the  field. 
Under  present  conditions  this  often  is  not  difficult,  for  few  may  know 
of  the  opportunity,  but  the  more  widespread  the  dissemination  of 
information,  and  the  more  general  the  disposal  to  act  upon  the  informa¬ 
tion  relative  to  new  opportunities,  the  more  likely  is  any  such  oppor¬ 
tunity  to  be  “  overexploited.”  In  other  words,  the  only  way  to 
eliminate  this  risk  is  to  provide  some  central  agency  through  which 
the  tasks  of  business  men  may  be  cleared  and  by  which  their  efforts 
may  be  apportioned  in  some  rational  way. 

Assume  a  given  population  and  a  given  amount  of  labor  to  be 
performed,  it  is  obvious  that  the  only  alternatives  are  first,  a  more  or 
less  random  distribution  of  the  employment,  or  second,  complete 
employment  for  some  and  unemployment  for  others,  or  third,  a 
rationing  of  labor  so  that  each  shall  get  part-time  employment.  This 
still  leaves  unanswered  one  fundamental  question:  Why  does  the 
volume  of  employment  remain  smaller  than  the  available  supply  of 
labor  ?  Why,  if  there  are  unemployed  reserves  of  labor,  does  it  not 
pay  someone  to  start  new  enterprises  to  take  up  this  slack?  For 
apparently,  it  must  be  possible  to  employ  the  men  in  such  a  way 
that  they  can  be  paid  more  than  they  can  get  doing  nothing,  and 
still  leave  some  profit  to  the  employer.1 

The  difficulty  seems  to  be  this:  that  entrepreneurs  hesitate  to 
make  investments  in  industries  unless  they  have  a  reasonable  assur¬ 
ance  of  being  able  to  get  a  sufficient  supply  of  labor  to  keep  the  capital 
busy,  and  the  exact  amount  to  be  needed  is  always  a  matter  of 
uncertainty.  Hence,  with  any  given  supply  of  labor,  the  extension 
of  industry  will  be  likely  to  stop  at  a  point  where  something  less  than 

1  It  should  be  noted  that  the  question  involved  here  is  not  the  question  of 
earning  even  a  living  wage,  for  if  there  are  more  laborers  than  can  be  employed  at 
a  living  wage,  it  would  still  be  profitable  to  employ  them  at  one-half  a  living  wage, 
which  is  better  in  most  men’s  estimation  than  nothing. 


26 


RISK  AND  RISK-BEARING 


full-time  employment  for  ioo  per  cent  of  the  people  is  afforded.  In 
the  case  of  the  dock  laborers,  a  supply  of  labor  only  sufficient  to  keep 
the  docks  busy  in  a  season  of  minimum  demand  would  mean  that  the 
docks  would  be  undermanned  at  busier  seasons.  Docks  simply  will 
not  be  built  up  to  that  point,  or  if,  through  error,  they  are  so  built, 
they  may  be  operated,  but  will  be  allowed  to  depreciate.  Apply  this 
line  of  reasoning  to  industry  at  large.  One  of  the  factors  with  which  the 
average  business  man  must  deal  is  the  possibility  of  securing  labor. 
If  the  labor  in  the  vicinity  is  already  95  per  cent  employed,  he  is 
much  less  likely  to  start  a  new  enterprise  than  if  it  is  only  90  per  cent 
employed.  If  the  labor  is  already  99  per  cent  employed,  no  enter¬ 
prise  can  start  unless  the  income  in  sight  is  sufficient  to  enable  it  to 
draw  away  its  labor  from  industries  already  existing.  The  result  of 
starting  such  an  enterprise  may  be  to  reduce  the  percentage  of 
unemployment  temporarily  to  zero,  but  such  a  situation  cannot 
persist.  The  new  enterprise  may  succeed,  but  its  success  would 
necessitate  the  failure  or  curtailment  of  operations  of  concerns  which 
were  in  a  weaker  position  and  could  not  count  on  drawing  their  labor 
supply  away  from  others.  There  must  be  some  reserve  for  contingencies. 
Operations  cannot  be  expanded  permanently  to  the  point  where  they 
require  all  the  available  supply  of  labor  and  leave  no  surplus  to  be 
drawn  upon  in  case  of  emergency.1 

The  situation  in  industries  is  similar  in  this  respect  to  that  which 
exists  in  a  military  campaign.  It  is  never  possible  to  have  all  the 
men  on  the  firing  fine  at  once.  Quite  apart  from  the  necessity  of 
utilizing  part  of  the  forces  in  auxiliary  functions  and  the  constant 
presence  of  a  hospital  reserve,  a  considerable  proportion  of  the  troops 
available  for  active  service  must  always  be  held  back  to  provide  for 
unexpected  contingencies.  Only  an  overwhelming  catastrophe  or  its 
imminent  prospect  will  call  into  action  the  total  available  forces. 

Closely  related  to  the  method  of  combination  to  reduce  risk  is  the  method 
of  compensation,  by  which  we  mean  the  adjustment  of  business  affairs 
in  such  a  way  that  losses  of  a  given  kind  will  be  directly  associated 
with  profits  of  another  kind.  This  differs  from  combination  in  that 
it  does  not  rely  upon  the  operation  of  chance  to  even  out  fluctuations 
but  seeks  to  match  one  fluctuation  directly  against  another.  Planting 

'Thus,  during  the  boom  of  1919,  new  industries  were  started  without  any 
source  for  their  labor  supply  except  labor  already  employed,  but  the  resulting 
“tightness”  of  the  labor  situation  was  a  major  factor  in  undermining  the  profits  of 
industry  and  shortening  the  boom. 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


27 


a  dry-weather  and  a  wet-weather  crop  in  the  same  year  is  an  illustra¬ 
tion.  Hedging  contracts  (see  chap,  xii)  combine  the  method  of  com¬ 
pensation  with  the  transfer  of  risk  to  specialists. 


NOTE  I 


THE  MATHEMATICS  OF  PROBABILITY 

In  connection  with  the  elimination  of  risk  by  combination  and  the 
estimation  of  degrees  of  risk,  frequent  reference  is  made  to  the  calculation 
of  probabilities.  It  seems  necessary,  therefore,  to  consider  somewhat  in 
detail  what  is  involved  in  the  discussion  of  probability  in  mathematical  terms. 

As  is  brought  out  more  fully  in  chapter  iii,  probabilities  are  of  three 
classes:  those  in  which  a  definite  mathematical  expression  of  probability 
can  be  attained  in  advance  of  the  occurrence  of  the  uncertain  event;  those 
in  which  such  a  probability  cannot  be  known  definitely  in  advance,  but  can 
be  established  from  the  observation  of  regularity  in  the  past  behavior  of  the 
phenomenon;  and  questions  of  judgment,  in  which  neither  a  mathematical 
nor  a  statistical  basis  of  calculation  exists.  We  are  not  concerned  at  this 
point  with  the  cases  of  judgment  (which  are  discussed  in  chapter  iii). 

Mathematical  probabilities  are  expressed  accurately,  and  statistical 
probabilities  approximately,  by  the  use  of  common  fractions.  A  probability 
of  for  instance,  means,  loosely  speaking,  that  the  event  in  question  is 
likely  to  happen  once  in  six  “trials.”  More  accurately  this  means  either 
that  there  are  six  equally  probable  situations,  one  of  which  constitutes  the 
event  whose  probability  we  are  measuring,  or  else  that  the  number  of 
equally  probable  cases  is  6 n,  n  of  which  are  classified  together,  any  one  of 
these  n  constituting  the  event  whose  probability  we  are  trying  to  state. 
Thus,  if  in  drawing  cards  from  a  full  pack  we  estimate  that  our  chance  of 
drawing  a  ten-spot  is  -il3",  what  we  mean  is  that  there  are  52  equally  probable 
events,  4  of  which  we  classify  as  “drawing  a  ten-spot,”  and  48  of  wjiich  we 
classify  as  “failing  to  draw  a  ten-spot.”  All  statements  of  probability  in 
exact  mathematical  terms  reduce  themselves  to  classifications  of  equally 
probable  events,  part  of  which  fall  within  and  part  without  a  given  category, 
and  comparing  the  number  of  those  within  with  those  without  the  category. 

Once  this  idea  is  understood,  the  mathematics  of  probability  resolves 
itself  into  a  consideration  of  mathematical  devices  for  simplifying  the  task 
of  enumerating  alternatives  within  or  without  the  categories  in  which  we 
are  interested.  Into  the  intricacies  of  probability  mathematics  we  need 
not  proceed  far;  one  or  two  illustrations  will  suffice  to  illustrate  certain 
principles  which  we  need  to  use. 

In  many  cases  the  probability  of  a  given  combination,  in  a  series  where 
each  result  is  one  of  two  equally  probable  events,  is  calculated  by  the  use 
of  the  familiar  binomial  theorem: 


(a-\-b)n  =  an -\-nan  lb-\-n 


(: n-i)an~2b 2 


n  (n  —  1 )  (w—  2 )an  3b 3 


+ 


.  +b 


n 


2 


2*3 


28 


RISK  AND  RISK-BEARING 


If  the  exponents  are  taken  to  represent  the  number  of  times  that  each  item 
occurs  in  the  combination  whose  probability  is  sought,  the  probability  will 
be  represented  by  the  fraction  whose  numerator  is  the  corresponding 
coefficient  and  whose  denominator  is  2  raised  to  the  nth  power.  For 
instance,  the  chance  of  throwing  heads  seven  times  in  succession  is  found 
by  taking  as  the  numerator  of  the  probability  fraction  the  coefficient  of 
a7;  in  this  case  unity.  Taking  27  as  the  denominator,  we  get  tTs  as  the 
result.  The  fourth  term  of  (a+6)7  is  35  a4  b 3;  the  chances  of  an  individual 
in  seven  trials  throwing  four  heads  and  three  tails  is  -AV 

The  reason  for  the  relationship  between  the  binominal  theorem  and  the 
calculus  of  probabilities  will  be  obvious  on  a  moment’s  consideration  of  the 
way  in  which  the  result  given  in  the  theorem  is  reached  through  actual 
multiplication.  In  multiplying  out,  there  is  only  one  combination  of  seven 
a’s;  there  are  35  combinations  of  four  a} s  and  three  6’s,  such  as  abababa; 
aaabbba ,  etc.  Likewise  in  tossing  the  coin  there  is  only  one  way  in  which 
seven  heads  can  be  tossed  in  succession,  while  there  are  35  ways  in  which 
seven  tosses  can  yield  four  heads  and  three  tails.  In  other  words,  there  are 
128  distinct  equally  probable  results,  35  of  which  are  classified  together  as 
“four  heads  and  three  tails.” 

The  probability  of  a  given  combination  in  a  series  of  events  each  of  which 
is  one  of  three  equally  probable  events,  is  similarly  calculable  by  using  the 
coefficients  of  ( a-\-b-\rc)n  to  obtain  the  desired  numerator,  and  3”  as  the 
denominator. 

The  combined  probability  of  two  independent  and  mutually  exclusive 
events,  that  is,  the  probability  of  their  both  happening,  is  the  product  of 
the  ratios  of  their  separate  probabilities.  For  instance,  if  the  chance  of  a 
certain  event  is  \  and  the  chance  of  another  is  the  chance  of  both  happening 
is  I,  provided  that  the  occurrence  of  the  one  does  not  change  the  probability 
of  the  other,  and  also  provided  that  they  cannot  both  happen  as  the  result 
of  the  same  outside  event.  The  chance  that  one  or  the  other  will  happen 
is  the  sum  of  their  respective  probabilities,  minus  the  probability  of  both 
happening.  The  chance  that  neither  will  happen  is  the  product  of  the 
separate  probabilities  that  each  will  not  happen. 

For  example,  if  the  probability  of  A’s  failure  within  60  days  is  estimated 
as  one  chance  in  100,  and  the  chance  of  B’s  failure  is  rated  as  one  chance  in 
200,  B’s  indorsement  on  A’s  note  would  reduce  the  probability  that  the  holder 
of  the  notes  may  suffer  a  loss  on  account  of  bankruptcy  to  one  chance  in 
20,000,  provided  neither  A  nor  B  was  a  customer  of  the  other,  or  involved 
in  business  relations  with  the  other  so  that  the  failure  of  one  would  greatly 
increase  the  probability  of  the  failure  of  the  other,  and  provided  that  their 
businesses  were  so  different  that  they  could  not  both  be  overthrown  by  a 
single  independent  cause.  In  practice,  of  course,  the  hazard  of  A’s  failure 
is  never  entirely  independent  of  the  hazard  of  B’s  failure.  Modern  business 
is  so  interdependent  that  the  events  which  cause  disaster  to  one  business 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


29 


are  likely  to  cause  disaster  to  many  others.  Wars,  financial  panics,  changes 
in  taxation,  new  inventions,  all  illustrate  the  extent  to  which  the  hazard 
of  businesses  in  a  single  community  and  even  throughout  the  civilized  world 
are  interdependent. 

The  most  important  practical  consequence  of  the  theory  of  mathematical 
probability  is  the  support  it  gives  to  the  empirical  “law  of  large  numbers.” 
It  has  long  been  observed  that  many  phenomena  which  display  a  high  degree 
of  irregularity,  so  far  as  the  individual  items  are  concerned,  are  highly 
regular  after  observation  is  fixed  on  the  behavior  of  groups  of  such  items. 
Thus  we  may  be  quite  sure  that  we  can  predict  within  30  per  cent  the  amount 
of  rainfall  which  will  occur  in  a  given  region  in  the  next  year,  while  if  we 
try  to  predict  the  precipitation  for  any  particular  day,  it  is  more  likely 
than  not  that  the  actual  result  will  be  either  less  than  10  per  cent  or  more 
than  1,000  per  cent  of  our  estimate.  So  with  death  rates,  marriages, 
enrolments  in  colleges,  desertions  from  the  army,  accidents  due  to  fireworks, 
and  thousands  of  other  contingencies.  A  single  event  defies  prediction, 
but  the  mass  remains  always  practically  the  same  or  varies  in  ways  which 
we  can  predict. 

An  examination  of  the  coefficients  secured  by  use  of  the  binomial 
theorem  shows  that  so  far  as  mathematical  probabilities  are  concerned,  the 
law  of  large  numbers  has  a  sound  scientific  basis.  For  example,  compare 
the  coefficients  secured  by  raising  (a-f-6)  to  the  seventh  power  with  those 
secured  by  raising  ( a-\-b )  to  the  eleventh  power.  In  the  first  case  the  sum 
of  the  coefficients  of  the  first  two  and  last  two  terms  is  16.  The  sum  of  the 
coefficients  of  the  middle  four  terms  is  112.  That  shows  that  the  chance 
of  securing  as  many  as  six  heads  or  as  few  as  one  head  out  of  seven  trials 
is  1126g  or  If  we  take  a  similar  result  for  the  eleventh  power,  the  sum 
of  the  coefficients  of  the  first  three  and  last  three  terms  is  134,  while  the  sum 
of  the  coefficients  of  the  middle  six  terms  is  1,914.  That  is,  the  chance  of 
getting  as  few  as  two  or  as  many  as  nine  heads  out  of  eleven  trials  is  134 
out  of  2,048,  or  about  one  in  15.  As  we  increase  the  number  of  terms  the 
probability  of  a  wide  divergence  of  the  actual  from  the  most  frequent 
result  declines  rapidly;  hence  more  accurate  prediction  becomes  possible. 
In  tossing  a  coin  32  times  there  is  only  one  chance  in  4,500  of  getting  27 
heads  or  27  tails;  in  tossing  500  times  the  probability 'that  the  number  of 
heads  will  be  between  200  and  300  is  nearly  1,000  to  1. 

Calculations  of  mathematical  probability  are  seldom  of  much  importance 
in  actual  business.  Actuaries  make  extensive  use  of  mathematical  proba¬ 
bility  in  determining  the  cost  of  specific  clauses  in  insurance  policies.  In 
this  case  the  original  probabilities  of  death  or  survival  are  not  mathematical 
probabilities.  They  are  merely  statistical  frequencies,  but  once  these 
ratios  are  assumed,  they  may  be  treated  as  though  they  were  mathematical 
probabilities.  For  example,  in  computing  the  premium  for  a  policy  which  is 
written  to  be  payable  at  the  death  of  one  or  the  other  of  two  persons,  the 


3° 


RISK  AND  RISK-BEARING 


calculation  of  combined  probability  of  death  within  a  given  period  is  a 
purely  mathematical  problem  similar  to  those  discussed  above,  once  the 
mortality  table  is  adopted.  The  separate  probabilities  rest  on  the  observa¬ 
tion  of  past  mortality,  which  it  is  assumed  will  continue. 

This  assumption  of  continued  regularity  is  itself  a  corollary  of  the  law  of 
large  numbers.  If  we  are  proposing  to  send  out  50,000  advertising  letters 
to  popularize  a  new  device,  we  are  very  much  interested  in  knowing  in 
advance  what  proportion  of  the  persons  to  whom  these  letters  are  sent 
will  be  likely  to  respond.  There  is  no  a  priori  method  of  calculating  the 
probability  of  a  given  individual’s  answering  such  a  letter.  Resort  must  be 
had  to  what,  in  the  terminology  of  statistics,  is  called  the  sampling  process. 
If  we  send  out,  say,  ten  letters  and  get  three  replies,  we  have  some  slight 
basis  for  judging  what  is  the  probability  of  the  average  prospect’s  answering. 
If  we  send  out  100  letters  and  get  30  replies,  we  have  a  surer  basis  of  judg¬ 
ment.  If  we  send  out  5,000  letters  to  prospects  taken  at  random  from  the 
list,  we  consider  ourselves  justified  in  assuming  that  the  ratio  of  replies 
received  to  the  5,000  letters  is  very  close  to  that  which  will  be  shown  by 
sending  out  the  entire  50,000.  The  basis  of  this  assumption  is  exactly  the 
same  as  the  basis  for  the  assumption  that  when  coins  are  tossed  a  large 
number  of  times  there  will  by  an  approximate  equality  between  the  number 
of  heads  and  number  of  tails  shown.  We  do  not  know  what  the  final  ratio 
of  answers  is  to  be,  but  we  assume  that  whatever  the  ratio  is  for  the  entire 
group,  the  ratio  for  a  group  of  5,000  will  not  diverge  widely  from  it.  The 
high  degree  of  success  which  has  attended  the  use  of  this  sampling  method 
in  such  widely  divergent  fields  as  market  research,  heredity,  weather 
forecasting,  and  the  transmission  of  disease,  makes  it  apparent  that  there  is 
some  force  at  work  establishing  regularity  of  recurrence  among  many 
phenomena  where  inspection  of  a  few  cases  seems  to  indicate  absolute 
unintelligibility. 

Presumably  the  situation  here  is  the  same  as  it  was  in  the  cases  of  pure 
mathematical  probability  discussed  before.  That  is,  there  is  an  inconceiv¬ 
ably  large  number  of  equally  probable  cases,  part  of  which  fall  within  the 
scope  of  one  of  our  classifications  and  part  within  the  other,  and  though  we 
cannot  calculate  in  advance  what  the  ratio  is,  it  is  perfectly  sound  scientific 
method  to  infer  a  law  from  a  regularity  running  through  a  large  number 
of  cases  and  use  it  as  a  basis  of  prediction  with  regard  to  the  rest.  This 
tendency  of  groups  to  display  variations  in  their  membership  in  definite 
ways  is  the  basis  of  all  social  science.  The  economist  recognizes  that  there 
are  individuals  who  display  no  acquisitive  bent,  but  he  knows  also  that 
in  any  large  group  such  individuals  are  in  a  small  minority,  and  he  bases 
his  theory  of  value  on  the  assumption  that  the  controlling  majority  in  any 
given  case  will  act  as  controlling  majorities  have  always  acted,  and  that  the 
abnormalities,  that  is,  the  infrequent  variations,  may  be  neglected.  So 
with  the  educator,  the  practical  politician,  and  the  penologist;  each  recog- 


WAYS  OF  DEALING  WITH  RISK:  ELIMINATION 


31 


nizcs  that  he  is  dealing  with  individuals  whose  behavior  is  in  large  measure 
unpredictable,  and  makes  no  pretense  of  being  able  to  offer  generalizations 
or  prescribed  rules  of  discipline  which  will  work  well  in  each  individual 
case,  but  he  does  claim  to  be  able  to  develop,  from  experience  and  study,  a 
program  which  will  achieve  predictable  results  in  a  large  and  fairly  definite 
percentage  of  cases. 

QUESTIONS 

1.  Illustrate  risk  being  reduced  (1)  by  increasing  our  knowledge  of  the 
future;  (2)  by  employing  safeguards;  (3)  by  insurance;  (4)  by  specu¬ 
lative  contracts;  (5)  by  social  control. 

2.  Is  it  possible  by  foresight  and  calculation  to  reduce  or  to  avoid  some  of 
the  risks  of  industry  ?  All  of  the  risks  of  industry  ? 

3.  Does  integration  reduce  risk? 

4.  Is  the  collection  of  statistics  by  trade  journals  a  co-operative  or  a 
specialized  method  of  reducing  risk  ? 

5.  Why  should  not  the  government  undertake  research  in  manufacture  on 
the  same  scale  as  in  agriculture  ? 

6.  “ A  strong  tendency  shows  itself  for  risky  enterprises  to  be  carried  on 
by  large  scale  methods.”  Why?  Cite  illustrations.  Can  you  cite 
illustrations  of  the  opposite  character  ? 

7.  Should  a  large  insurance  company  be  able  to  give  better  rates  than  a 
small  one? 

8.  How  does  incorporation  aid  in  lessening  risk?  Does  the  feature  of 
limited  liability  reduce  risk  or  merely  transfer  it  ? 

9.  Specifically,  what  inconveniences  would  business  men  suffer  if  the 
reserve  of  unemployed  labor  were  eliminated  ? 


CHAPTER  III 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 
TO  OTHERS;  ASSUMPTION  OF  RISK 

The  methods  outlined  in  the  preceding  chapter  are  not  adequate  to 
remove  nearly  all  of  the  uncertainties  of  production,  and  consequently 
it  is  necessary  for  someone  to  bear  the  risks  which  are  not  so  removed. 
It  is  not  necessary,  however,  that  the  brunt  of  this  risk-bearing  should 
be  borne  by  the  individuals  upon  whom  it  falls  in  the  first  instance. 
Here,  as  elsewhere,  in  modern  business  the  principle  of  specialization 
has  been  found  useful,  and  much  of  the  complexity  of  our  industrial 
and  commercial  system  is  the  result  of  attempts  to  relocate  the  burden 
of  risk.  Usually  the  transfer  is  combined  with  some  other  method 
of  risk  reduction.  Frequently,  for  example,  specialization  in  risk¬ 
bearing  is  associated  with  the  reduction  of  risk  through  combination, 
as  is  the  case  in  most  insurance.  The  fire  insurance  company,  for 
instance,  by  insuring  a  large  number  of  houses  in  scattered  localities, 
changes  the  small  risk  of  a  ioo  per  cent  loss  into  the  practical  certainty 
of  a  small  loss;  hence  the  transfer  of  the  risk  is  a  social  gain.  Some¬ 
times  a  transfer  results  in  risk  reduction  through  more  successful 
forecasting  on  the  part  of  the  specialist.  For  example,  an  investment 
bank  is  able  to  assume  the  risks  connected  with  floating  new  bond 
issues  better  than  can  many  borrowing  corporations  in  part,  because 
of  its  special  expertness  in  judging  market  conditions,  hence  assumes 
the  risk  by  underwriting  the  issues,  i.e.,  guaranteeing  their  success.1 
Sometimes  transfer  is  associated  with  prevention,  as  when  a  company 
insuring  steam  boilers  provides  an  inspection  service  designed  to  pre¬ 
vent  explosions,  or  a  life  insurance  company  contributes  to  the  support 
of  a  public  nurse.  Occasionally  the  transfer  results  merely  in  a 
transfer  of  the  risk  to  someone  better  able,  or  more  willing,  to  bear 
it,  as  is  the  case  in  most  speculative  contracts. 

For  purposes  of  discussion  it  is  convenient  to  divide  the  subject 
of  risk  reduction  through  transfer  into  three  principal  topics:  The 
specialization  of  business  men  as  a  class  in  carrying  the  risks  of  ordinary 

1  There  is  also  some  combination  of  risk  involved  in  this  transfer,  and  sometimes 
some  prevention ,  if  the  underwriter  undertakes  the  active  management  of  the 
selling. 


32 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


33 


business,  which  forms  the  subject-matter  of  the  remainder  of  this 
chapter;  the  specialization  of  investors  in  carrying  various  kinds  and 
degrees  of  risk,  discussed  in  chapters  vii  to  xi,  and  the  organization 
of  special  agencies  for  shifting  special  types  of  risk,  which  are  dealt 
with  in  chapters  iv  and  xii  to  xvii. 

The  typical  organization  of  modern  business  involves  specialization 
in  risk-bearing .  The  ordinary  relationship  between  employer  and 
employee,  between  borrower  and  lender,  may  not  appear,  at  first 
glance,  to  illustrate  the  transfer  of  risk,  but  a  moment’s  reflection  will 
show  that  that  is  exactly  what  its  purpose  is.  When  a  business  is 
organized,  the  owner  of  the  business,  his  creditors,  and  his  employees 
enter  into  a  co-operative  scheme  for  carrying  on  production,  each 
specializing  in  furnishing  certain  services.  The  labor  group  furnish 
their  time,  skill,  and  energy.  The  capitalist-lender  furnishes  the  use 
of  his  capital.  The  owner  furnishes  part  of  the  capital  and  part  of 
the  time  and  skill,  and  assumes  the  responsibility  for  determining 
the  fundamental  policies  of  the  business.  The  risk  is  divided  between 
them.  The  laborer  assumes  most  of  the  risks  of  physical  harm,  which 
arise  in  the  processes  of  production,  though  the  modern  tendency  is 
to  transfer  the  financial  hazard  of  accidents  in  large  part  to  the 
employer.  The  laborer  also  assumes  the  risk  that  if  the  enterprise 
is  unsuccessful,  or  if  it  develops  in  such  a  way  that  his  services  are  no 
longer  needed,  he  will  find  himself  left  without  employment.  The 
capitalist-lender  subjects  his  investments  to  the  hazard  of  complete 
loss  if  the  business  proves  so  unsuccessful  that  the  entire  capital 
invested  in  the  business  is  sunk  so  that  the  loans  cannot  be  repaid. 

The  owner-manager  assumes  the  risk  of  failure  just  so  far  as  his 
resources  are  sufficient  to  cover  that  risk.  He  is  the  primary  risk 
bearer;  if  financial  loss  falls  on  the  others,  it  is  chiefly  because  he  evades 
or  is  unable  to  meet,  his  responsibility.  In  meeting  this  responsi¬ 
bility,  the  owner-manager  has  a  large  measure  of  freedom  of  choice 
of  methods.  As  was  pointed  out  in  chapter  ii,  he  finds  it  advantageous 
to  undertake  research  in  order  to  reduce  the  range  of  uncertainty 
with  which  he  has  to  deal.  He  may  transfer  a  part  of  his  burden  to 
specialists.  Certain  risks,  however,  he  must  assume,  and  others  he 
is  likely  to  assume. 

It  will  be  noted  that  the  form  in  which  the  risk  of  business  falls 
upon  the  owner-manager  is  essentially  different  from  the  way  in 
which  the  risk  falls  upon  the  other  members  of  the  co-operating 
organization.  So  long  as  the  system  functions  in  the  way  it  is  intended 


34 


RISK  AND  RISK-BEARING 


to  function,  the  product  of  any  industry  is  divided  by  withdrawing 
first  the  shares  of  the  laborers  and  the  outside  lenders,  which  are 
fixed  in  advance  by  agreement,  and  leaving  the  remainder  for  the 
owner-manager.  The  laborer  who  puts  his  time  into  a  given  pro¬ 
ductive  process  is  guaranteed  a  certain  wage  and  is  entitled  to  that 
wage  whether  the  enterprise  succeeds  or  not.  Likewise  the  capitalist 
who  lends  his  money  to  the  business  is  entitled  to  his  interest,  whether 
the  enterprise  succeeds  or  not.  In  theory  not  only  the  capital 
invested  by  the  owner  but  any  other  resources  which  he  may  have 
must  be  exhausted  before  the  loss,  in  case  of  failure,  can  properly 
be  assessed  upon  the  co-operating  capitalists  and  wageworkers. 
The  risk  which  falls  upon  the  latter  groups,  therefore,  is  relatively 
remote,  and  losses  fall  upon  them  only  in  case  the  owner-manager, 
who  is  responsible  for  carrying  the  risks  of  the  business,  is  unable  to 
meet  his  responsibility.1  The  return  of  the  owner-manager,  on  the 
other  hand,  is  subject  to  the  entire  risk  of  the  business.  This  is  true 
in  the  nature  of  the  case  not  only  of  those  businesses  where  there  is 
real  risk  of  failure,  but  also  in  cases  where  success  is  practically  assured, 
for  it  is  almost  never  true  that  the  exact  amount  of  the  total  income 
of  the  business  is  known  in  advance,  and  whatever  uncertainty  exists 
is  concentrated  upon  the  share  of  the  owner-manager.  As  a  result 
the  share  of  the  owner-manager  has  a  much  wider  proportionate  range 
of  fluctuation  than  does  the  income  of  the  business  as  a  whole.  If, 
for  instance,  the  gross  income  of  a  business  varies  from  $800  to  $1,200, 
and  the  interest  and  wage  bills  absorb  $600,  the  income  of  the  owner- 
manager  will  fluctuate  from  $200  to  $600.  A  variability  of  50  per 
cent  in  the  income  of  the  enterprise  results  in  a  variability  of  200 
per  cent  in  the  owner’s  share. 

This  is  the  characteristic  which  distinguishes  profit,  on  the  one 
hand,  from  wages  and  interest,  on  the  other.  Profit  is  known  only 
as  the  results  of  the  undertaking  become  evident,  and  fluctuates  with 
every  factor  which  changes  those  results,  while  wages  and  interest, 
whether  paid  to  outsiders  or  “imputed”  to  the  owner’s  own  labor 
and  capital,  are  determined  in  some  way  in  advance.  It  follows,  of 
course,  that  in  a  given  case  the  profit  may  turn  out  to  be  a  minus 
quantity.  If  the  return  of  the  enterprise  falls  short  of  the  interest 
and  wages  agreed  upon,  the  difference  is  called  a  “loss”  instead  of  a 
profit. 

1  The  necessary  qualifications  of  this  statement,  with  reference  to  corporations 
and  limited  partnerships  and  other  cases  of  limited  liability,  are  discussed  below, 
chap,  xviii. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


35 


Whether  business  enterprise ,  as  a  whole,  yields  an  average  profit 
or  an  average  loss  is  an  open  question.  The  traditional  economic 
view  is  that  both  profit  and  loss  tend  to  disappear.  Under  free 
competition,  capital  and  labor  tend  to  flow  into  the  most  profitable 
openings  that  are  available  and  to  move  out  of  the  unprofitable. 
Given  time  enough  and  knowledge  enough,  any  opportunity  wherein 
the  return  remains  much  above  the  market  value  of  the  resources 
which  it  utilizes  will  draw  to  itself  such  a  volume  of  capital  and  labor 
that  the  return  to  capital  in  it  will  be  lowered  to,  or  below,  the  normal 
rate  by  the  ordinary  effect  of  competition,  and  in  any  enterprises 
where  the  return  is  below  normal,  capital  will  flow  out  until  the  reduced 
volume  of  production  brings  the  return  up  to  normal.  This  process 
is  never  complete,  because  new  inequalities  are  constantly  appearing 
as  old  inequalities  are  being  flattened  out.  The  process  is  like  the 
processes  by  which  the  surface  of  the  sea  seeks  its  level.  No  one 
ever  saw  the  sea  level,  yet  at  every  moment  the  crests  of  the  waves 
are  being  flattened  and  the  troughs  filled  through  the  ceaseless  opera¬ 
tion  of  the  force  of  gravity.  In  like  manner  the  crests  of  profits  and 
the  troughs  of  loss  are  being  flattened  out  by  the  force  of  competition. 
The  concept  of  the  normal  return  is  used  just  as  is  the  concept  of  the 
sea  level  as  a  base  line  from  which  to  measure  deviations,  not  as  a 
description  of  the  condition  existing  at  any  moment.  The  hope  of 
profit  is  the  inducement  to  incur  a  risk,  and  the  result  of  the  attempt 
to  secure  profit  is  to  destroy  the  opportunity  to  do  so.  Hence, 
profit  consists  of  a  series  of  temporary  returns,  not  a  continuous  flow 
of  income. 

This  analysis  holds  good,  however,  only  so  far  as  the  uncertainty 
which  makes  profit  possible  actually  does  disappear.  As  Cliffe  Leslie 
pointed  out  many  years  ago,  the  operation  of  such  a  tendency  is 
contingent  upon  the  assumption  that  the  conditions  of  profit  and  loss 
become  known,  an  assumption  to  which  exceptions  are  innumerable: 

The  full  knowledge  and  foreknowledge  lately  claimed  for  political 
economy  in  modern  commercial  society  can  exist  only  at  an  opposite  state 
of  development,  at  which  human  business  and  conduct  are  determined, 
not  by  individual  choice,  or  the  pursuit  of  wealth,  or  commercial  principles, 
but  by  immemorial  ancestral  custom.  All  that  relates  to  the  occupations 
and  movements  of  a  nomad  tribe  in  Central  Asia  is  known  and  foreknown 
by  all  its  members.  At  the  more  advanced  states  of  early  agricultural 
society  the  power  of  prediction  continues.  Dynasties  rise  and  fall,  con¬ 
querors  come  and  go,  empires  are  shattered  above  the  head  of  the  village 
community;  yet  it  survives  unchanged . 


36 


RISK  AND  RISK-BEARING 


But  just  in  proportion  as  the  stationary  passes  into  the  progressive 
condition,  as  industry  and  commerce  are  developed,  does  the  social  economy 
become  complex,  diversified,  changeful,  uncertain,  unpredictable,  and  hard 
to  know,  even  in  its  existing  phase,  at  any  given  time.  In  the  primitive 
village  community  the  prices  of  commodities  and  the  gains  of  producers 
are  not  only  known,  but  foreknown,  because  they  are  customary  prices. 
But  when  a  market  grows  upon  the  border,  when  dealings  with  strangers 
are  unrestricted  by  the  tie  of  kinship  or  community,  or  by  usage,  the  prices 
at  which  things  are  bought  and  sold  can  no  longer  be  known  beforehand, 
and  are  not  even  necessarily  known  to  everyone  afterwards.  Production 
can  no  longer  be  exactly  adjusted  to  consumption,  supply  to  demand,  both 
the  number  and  the  means  of  customers  from  without  being  unknown. 
And  as  industrial  development  proceeds;  as  labour  is  subdivided,  and 
occupations  multiply,  and  the  methods  of  production  improve;  as  commerce 
enlarges  its  borders  and  changes  its  paths,  the  unknown  more  and  more 
takes  the  place  of  the  known.  The  desire  of  wealth,  or  of  its  representative 
—  money— instead  of  enabling  the  economist  to  foretell  values  and  prices, 
destroys  the  power  of  prediction  that  formerly  existed,  because  it  is  the 
mainspring  of  industrial  and  commercial  activity  and  progress,  of  infinite 
variety  and  incessant  alteration  in  the  structure  and  operations  of  the 
economic  world. 

Just  as  from  the  strength  of  the  impulses  to  marriage,  together  with 
observations  of  their  consequences,  you  may  predict  that,  other  circum¬ 
stances  remaining  the  same,  nearly  the  same  number  of  young  men  in  busi¬ 
ness  will  marry  this  year  as  last;  so  from  the  strength  in  this  country'  of 
pecuniary  interest,  and  the  course  of  conduct  it  has  been  found  for  centuries 
to  lead  to,  you  may  predict  that,  if  business  does  not  greatly  fall  off,  about 
the  same  number  of  young  men  will  go  into  it  this  year  as  last.  But  you 
can  no  more  predict  from  their  love  of  money  what  prices  and  profits  the 
young  men  will  get  in  their  business  than  from  their  love  of  fair  women 
what  fortune  they  will  get  with  their  wives.  And  you  might  as  well  assume 
that,  allowing  for  difference  of  age,  looks,  and  family,  and  other  attractions, 
the  fortunes  the  wives  bring  will  be  equal,  as  that,  allowing,  according  to 
the  orthodox  formula,  for  differences  in  the  nature  of  their  employment, 
they  will  make  equal  rates  of  profit  on  their  capital.  Here  the  real  main 
postulate  of  the  deductive  economist  comes  in.  They  cannot,  he  says, 
make  a  higher  rate  of  profit  in  one  business  than  in  another,  because  other 
people  will  not  allow  that  if  they  know  it,  but  will  cut  in  at  once.  And  he 
assumes  that  they  do  know  it.  He  assumes  that  the  choice  of  occupations 
and  investments,  and  the  movements  cf  labour  and  capital,  are  determined 
by  knowledge  so  accurate  that  the  result  is  the  same  percentage  of  profit 
on  capital  all  round,  and  a  scale  of  comparative  prices  in  proportion  to  the 
quantity  and  quality  of  the  labour  and  sacrifices  required  to  produce 
commodities,  or  their  comparative  cost  of  production. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


37 


Even  in  a  modern  village  the  innkeeper,  publican  or  shopkeeper,  who 
is  making  a  small  fortune,  does  not  invite  competition  by  telling  his  neigh¬ 
bours  of  his  profits;  and  the  man  who  is  not  doing  well  does  not  alarm  his 
creditors  by  exposing  the  state  of  his  affairs.  If  you  take  a  whole  country 
like  England,  it  becomes  a  matter  of  accident,  situation,  and  personal 
history  and  connexion,  what  a  man  knows  about  the  state  of  any  particular 
business. 

In  both  home  trade  and  international  trade  the  migration  of  labour 
and  capital  has  some  effect  on  wages  and  profits,  and  the  comparative  cost 
of  producing  different  commodities  some  effect  on  their  comparative  value 
and  price;  but,  in  both  cases  the  effect  is  uncertain,  irregular,  and  incalcu¬ 
lable.  In  neither  case  is  there  an  equalization  of  either  wages  or  profits. 
If  a  particular  business  is  known  or  believed  to  be  flourishing,  capital 
flows  into  it;  but  it  also  flows  into  businesses  that  are,  in  reality,  very 
unprosperous.  One  has  only  to  keep  one’s  eyes  open  in  the  streets  of 
London  to  see,  year  after  year,  shops  fail,  disappear,  and  reappear  with 
another  name  over  the  window,  though  the  locality  evidently  does  not 
support  them.  Save  in  so  far  as  the  prosperity  of  their  own.  business 
depends  on  that  of  others,  the  people  in  one  trade  know  little  or  nothing 
of  the  condition  of  other  trades,  or  no  more  than  the  newspapers  tell  them. 

In  truth,  the  choice  of  employment  runs  in  a  very  narrow  groove. 
There  is,  no  doubt,  a  tendency  of  trades  to  localize  themselves,  like  cotton 
manufacture  in  Lancashire,  in  the  places  with  the  best  natural  aptitudes  for 
them.  But  in  the  degree  and  manner  in  which  this  localization  takes  place 
it  is  largely  the  result  of  want  of  information,  and  want  of  originality  and 
enterprise,  and  is  far  from  effecting  the  best  distribution  of  industry.  Men 
follow  each  other,  like  sheep,  in  flocks,  though  the  sheep  are  not  wise  in 
inferring  that  wherever  there  is  enough  good  grass  for  a  few,  there  must 
be  plenty  for  the  whole  flock  that  goes  after  them.1 

So  much  may  be  said  for  the  doctrine  that  profits  tend  to  dis¬ 
appear.  Other  students  believe  that  there  is  a  tendency  to  a  perma¬ 
nent  positive  return,  not  received  by  all  business  men  but  received  by 
the  average  business  man,  and  constituting  the  reward  of  the  owner- 
manager  group  as  a  whole  for  the  service  of  risk-bearing.  Their 
reasons  for  this  belief  may  be  stated  as  follows:  Of  two  opportunities, 
if  one  offers  a  certain  return  of  6  per  cent,  while  the  other  may  yield 
anywhere  from  nothing  to  12  per  cent,  the  former  is  the  more  attrac¬ 
tive.  Other  things  being  equal,  people  prefer  to  put  their  capital  into 
enterprises  which  offer  the  certainty  of  a  given  return  rather  than 
into  those  which  offer  a  probability  of  the  same  return  but  no  certainty. 

1  Adapted  from  Thomas  E.  C.  Leslie,  “The  Known  and  the  Unknown  in  the 
Economic  World,”  Fortnightly  Review ,  XXXI  (1879),  pp.  934-49. 


38 


RISK  AND  RISK-BEARING 


Hence,  doubtful  enterprises  do  not  attract  capital  in  sufficiently 
large  quantity  to  bring  the  return  in  them  down  to  the  same  average 
level  as  in  safe  enterprises,  but  only  down  to  the  level  where  the 
most  probable  difference  is  sufficient  to  overcome  the  disinclination 
to  incur  risk.  Profit  is  therefore  a  permanent  and  necessary  part  of 
the  social  dividend  and  is  accounted  for  as  the  only  incentive  to  render 
the  service  of  “uncertainty  bearing,”  which  is  as  essential  a  service 
as  that  of  saving  capital  or  doing  work. 

This  reasoning  is  probably  correct,  at  least  for  certain  types  of 
risk,  but  it  is  by  no  means  conclusive.  It  is  clear  that  the  hope  of 
profit  is  the  incentive  leading  men  to  put  their  capital  at  risk  rather 
than  to  put  it  in  safe  investments,  but  it  does  not  necessarily  follow 
that  speculative  enterprises  as  a  whole  must  necessarily  return  a 
profit  to  their  owners.  It  is  only  necessary  that  there  be  a  sufficient 
number  of  successful  enterprises  to  keep  the  hope  of  profit  alive. 
Some  men,  indeed,  are  so  conservative  and  cautious  that  they  must 
have,  not  only  the  possibility,  but  a  high  probability  of  a  return 
before  subjecting  their  capital  to  unnecessary  risk,  but  the  necessity 
of  society’s  paying  profit  to  business  men  does  not  rest  upon  the 
cautiousness  of  the  most  cautious  or  even  the  average  man.  All 
that  is  necessary  is  that  for  enterprises  with  a  given  degree  of  risk 
there  shall  be  a  sufficient  prospective  profit  to  attract  thither  the 
capital  of  those  individuals  who  are  least  concerned  about  risk  (or 
those  for  whom  the  risk  is  least),  in  sufficient  numbers  to  exploit 
the  opportunity.  And  it  is  by  no  means  certain  that  for  business 
enterprises  as  a  whole  this  necessitates  a  positive  level  of  profit. 
Certainly  there  are  many  enterprises  in  which  society  is  served  by 
uncompensated  risk-bearers.  Prospecting  for  gold  is  generally 
believed  to  be  a  case  in  point,  and  developing  new  inventions  is 
probably  another. 

Many  men  are  disposed  to  underrate  risk  where  their  own  interests 
are  involved,  and  society  reaps  the  benefit  of  their  error.  Adam 
Smith’s  observations  on  this  point  are  as  sound  today  as  they  were 
in  1 776 11 

That  the  chance  of  gain  is  naturally  over-valued,  we  may  learn  from 
the  universal  success  of  lotteries.  The  world  neither  ever  saw,  nor  ever 
will  see,  a  perfectly  fair  lottery;  or  one  in  which  the  whole  gain  compensated 
the  whole  loss;  because  the  undertaker  could  make  nothing  by  it.  In  the 

1  For  a  qualification,  however,  cf.  chap,  vii 


WAYS  OF  DEALING  WITH  RISK.  TRANSFER 


39 


state  lotteries  the  tickets  are  really  not  worth  the  price  which  is  paid  by 
the  original  subscribers,  and  yet  commonly  sell  in  the  market  for  twenty, 
thirty,  and  sometimes  forty  per  cent  advance.  The  vain  hope  of  gaining 
some  of  the  great  prizes  is  the  sole  cause  of  this  demand.  The  soberest 
people  scarce  look  upon  it  as  a  folly  to  pay  a  small  sum  for  the  chance  of 
gainihg  ten  or  twenty  thousand  pounds;  though  they  know  that  even  that 
small  sum  is  perhaps  twenty  or  thirty  per  cent  more  than  the  chance  is 
worth.  In  a  lottery  in  which  no  prize  exceeded  twenty  pounds,  though  in 
other  respects  it  approached  much  nearer  to  a  perfectly  fair  one  than  the 
common  state  lotteries,  there  would  not  be  the  same  demand  for  tickets. 
In  order  to  have  a  better  chance  for  some  of  the  great  prizes,  some  people 
purchase  several  tickets,  and  others,  small  share  in  a  still  greater  number. 
There  is  not,  however,  a  more  certain  proposition  in  mathematics  than  that 
the  more  tickets  you  adventure  upon,  the  more  likely  you  are  to  be  a  loser. 
Adventure  upon  all  the  tickets  in  the  lottery,  and  you  lose  for  certain; 
and  the  greater  the  number  of  your  tickets  the  nearer  you  approach  this 
certainty. 

The  contempt  of  risk  and  the  presumptuous  hope  of  success  are  in  no 
period  of  life  more  active  than  at  the  age  at  which  young  people  choose 
their  professions.  How  little  the  fear  of  misfortune  is  then  capable  of 
balancing  the  hope  of  good  luck  appears  still  more  evidently  in  the  readiness 
of  the  common  people  to  enlist  as  soldiers,  or  to  go  to  sea,  than  in  the 
eagerness  of  those  of  better  fashion  to  enter  into  what  are  called  the  liberal 
professions. 

In  all  the  different  employments  of  stock,  the  ordinary  rate  of  profit  varies 
more  or  less  wfith  the  certainty  or  uncertainty  of  the  returns.  These  are 
in  general  less  uncertain  in  the  inland  than  in  foreign  trade,  and  in  some 
branches  of  foreign  trade  than  in  others;  in  the  trade  to  North  America,  for 
example,  than  in  that  to  Jamaica.  The  ordinary  rate  of  profit  always  rises 
more  or  less  with  the  risk.  It  does  not,  however,  seem  to  rise  in  proportion 
to  it,  or  so  as  to  compensate  it  completely.  Bankruptcies  are  most  frequent 
in  the  most  hazardous  trades.  The  most  hazardous  of  all  trades,  that  of  a 
smuggler,  though  when  the  adventure  succeeds  it  is  likewise  the  most 
profitable,  is  the  infallible  road  to  bankruptcy.  The  presumptuous  hope 
of  success  seems  to  act  here  as  upon  all  other  occasions,  and  to  entice  so 
many  adventurers  into  those  hazardous  trades,  that  their  competition 
reduces  their  profit  below  what  is  sufficient  to  compensate  the  risk.  To 
compensate  it  completely,  the  common  returns  ought,  over  and  above 
the  ordinary  profits  of  stock,  not  only  to  make  up  for  all  occasional  losses, 
but  to  afford  a  surplus  profit  to  the  adventurers  of  the  same  nature  with 
the  profit  of  insurers.  But  if  the  common  returns  were  sufficient  for  all  this, 
bankruptcies  would  not  be  more  frequent  in  these  than  in  other  trades.1 

1  Smith,  Wealth  of  Nations,  Book  I,  chap.  x. 


40 


RISK  AND  RISK-BEARING 


The  common  statement  that  profit  is  the  “reward”  of  risk¬ 
bearing  means  simply  that  the  hope  of  profit  is  the  inducement  which 
leads  men  to  incur  the  risk  of  a  loss,  not  that  the  profit  actually 
attained  in  a  given  case  bears  a  predictable  relation  to  the  amount  of 
risk  actually  undergone  in  that  case.  Obviously  there  is  no  conscious 
purpose  on  anybody’s  part  to  “reward”  the  risk-taker. 

The  only  way  in  which  risk  enables  an  individual  to  secure  a 
profit  is  by  its  tendency  to  keep  others  out  of  the  field.  What  we 
have  to  deal  with  is  a  constant  shifting  of  capital  from  one  field  to 
another  in  the  effort  to  secure  the  maximum  return  for  individual 
owners.  The  greater  the  number  of  capitalists  who  strive  to  enter 
a  given  field,  the  less  the  prospect  of  profit  from  investment  in  that 
field,  and  the  less  the  risk  the  greater  that  number  is  likely  to  be. 
Almost  any  other  force  which  limits  the  amount  of  capital  available 
for  investment  in  a  particular  line  may  give  rise  to  profit  in  the  same 
way.  The  only  reason  economists  have  fixed  upon  risk  as  the  source 
of  profit  is  its  frequency,  for  if  a  given  line  of  endeavor  offers  with 
certainty  more  than  the  market  rate  of  interest  and  wages  to  those 
who  engage  in  it,  the  other  deterrents  are  rarely  effective.  If,  for 
instance,  we  had  numerous  cases  of  high  profits  in  certain  lines  caused 
by  social  disapproval  of  the  enterprises,  we  should  have  to  develop 
courses  in  odium  and  odium-bearing  to  complete  our  survey  of  the 
quest  of  profits.  Such  cases  are  not  unknown,1  but  aside  from  monop¬ 
oly  they  are  so  few,  comparatively  speaking,  that  there  is  no  material 
error  in  assuming  that  absolutely  certain  opportunities  for  getting 
more  than  a  normal  return  without  monopoly  simply  do  not  exist. 

This  does  not  mean,  however,  that  the  uncertainty  to  be  effective 
must  be  present  in  everyone’s  mind,  least  of  all  in  the  mind  of  the 
profit-seeker.2  Profits  are  made  most  successfully  by  those  who 
know  first  and  reap  an  advantage  from  the  uncertainty  in  other 
men’s  minds.  As  Hadley  puts  it: 

Many  of  the  writers  who  treat  of  the  relation  between  business  risk 
and  business  profit  make  the  mistake  of  assuming  that  profits  are  an  amount 

1  Money-lending  in  the  Middle  Ages  and  the  “white  slave  traffic”  in  modern 
times  are  illustrations. 

1  In  this  respect  the  relation  between  uncertainty  and  profit  is  similar  to  that 
between  other  elements  of  distribution  and  the  services  which  they  “reward.” 
For  instance,  wages  may  be  regarded  as  an  incentive  to  overcome  laziness,  but  this 
does  not  mean  they  will  be  withheld  from  those  who  prefer  work  to  leisure.  They 
reward  those  who  relieve  the  rest  of  society  from  overcoming  its  laziness.  Again 
interest  as  the  “reward  of  abstinence”  is  the  due  of  those  whose  saving  involves  no 
conscious  abstinence  at  all,  as  long  as  some  saving  involves  the  exercise  of  abstinence. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


41 


paid  to  the  individual  capitalist  to  cover  his  risk  of  loss.  Far  from  it. 
They  are  paid  to  capitalists  as  a  class  for  protecting  the  public  against  its 
risk  of  loss.  They  are  charges  which  the  capitalists  make,  not  for  insuring 
themselves,  but  for  insuring  society  against  the  losses  incident  to  industrial 
experiment  and  industrial  progress.1 

Or  in  the  words  of  a  German  economist  of  a  generation  ago: 

The  entrepreneur  must  always  to  a  certain  extent  carry  risk,  the  risk 
of  both  a  technical  and  an  economic  failure  of  production.  But  the  signifi¬ 
cance  of  the  risk  depends  on  the  individual.  To  walk  on  a  tight  rope  over 
an  abyss  is  obviously  a  frightfully  risky  thing  for  an  ordinary  mortal,  but 
for  a  trained  acrobat  walking  on  the  rope  may  involve  no  special  risk  at 
all.  So  it  is  with  the  entrepreneur.  A  business  man  versed  in  the  technique 
of  industry  and  commerce  knows  the  art  of  keeping  his  balance  and  under¬ 
stands  how  to  take  business  risks  with  success;  it  does  not  appear  to  him 
a  perilous  thing  to  establish  and  carry  on  a  business,  while  a  novice  shrinks 
from  the  risk.2 

To  state  the  point  more  precisely,  the  significance  of  risk  as  a 
source  of  profit  depends  in  each  case  on  its  effectiveness  as  a  deterrent 
to  competitive  efforts  to  exploit  the  given  opportunity,  and  its  effec¬ 
tiveness  depends  on  the  degree  of  uncertainty  inherent  in  the  situation, 
the  number  of  people  to  whom  the  probability  of  success  appears 
great,  their  attitude  toward  the  taking  of  risk,  and  the  amount  of 
capital  they  control.  If  the  “supply  of  entrepreneur  ability”  is  large 
either  because  the  uncertainty  in  many  people’s  calculations  is  small 
or  because  a  reckless  attitude  prevails,  risky  enterprises  will  be 
developed  and  the  percentage  of  failures  will  be  high.  Whether  the 
average  level  of  profit  is  high  or  low,  whether  indeed  it  exists  at  all 
as  a  positive  quantity,  seems  to  be  a  question  of  local  circumstances 
about  which  no  general  statement  of  value  can  be  made.3 

1  Economics ,  pp.  288-89. 

2  Kleinwachter ,  Das  Einkommen  und  seine  Verteilung ,  p.  287.  (Leipzig,  1896.) 

3  Cannan  suggests  that  both  very  risky  and  very  safe  enterprises  yield  less 
than  an  average  return  because  of  their  undue  attraction  for  people  of  abnormally 
high,  or  abnormally  low,  caution.  (Palgrave,  Dictionary  of  Political  Economy, 
article  on  “Profit.*’)  This  conclusion  seems  to  be  verified  by  tentative  results  of 
studies  of  returns  of  stocks  and  bonds  made  under  the  author’s  direction,  but  this 
evidence  is  not  yet  complete  enough  to  warrant  a  positive  statement. 

The  statistical  evidence  from  income  studies  is  inadequate.  King  found 
(' Wealth  and  Income  of  the  People  of  the  United  States,  p.  168)  that  owners  of  business 
made  a  somewhat  higher  return  than  hired  laborers  ($899  as  compared  with  $507, 
in  1910),  but  this  difference,  after  allowance  is  made  for  interest  on  invested  capital, 
may  be  no  greater  than  the  average  difference  in  wage-earning  capacity  of  the  two 


42 


RISK  AND  RISK-BEARING 


Where  monopoly  exists  it  is  possible  to  sell  goods  at  a  price  yielding 
a  profit,  sometimes  an  enormous  profit  above  the  cost  incurred, 
without  apparent  risk.  In  these  cases  the  conditions  which  give  rise 
to  monopoly — such  as  patent  rights,  terrorism,  limitation  of  natural 
resources — operate  to  protect  the  investor  from  competition  just  as 
in  the  cases  we  have  been  considering  risk  operates  to  protect  him. 
Whatever  causes  operate  to  check  the  flow  of  investment  into  a 
given  industry  may  give  rise  to  an  opportunity  for  profit  in  it;  the 
cause  of  the  monopoly  operates  just  as  risk  does,  but  more  effectively.* 1 

The  securing  of  monopolies  is  an  extremely  profitable  business  for 
the  few  who  succeed  in  it. — It  does  not  seem,  however,  to  be  more 
free  from  risk  than  any  other  business.  The  development  and 
early  financing  of  inventions  is  notoriously  speculative.  Obtaining 
franchises  to  establish  public  services  may  not  involve  much  risk  for  a 
few  whose  connections  enable  them  to  do  it  most  successfully,  but 
their  success  is  clearly  conditioned  on  the  degree  of  ignorance  or 
uncertainty  on  the  part  of  the  public  from  whom  they  get  the  privilege, 
or  of  rival  investors  who  might  otherwise  bid  for  it. 

Most  sources  of  profit  involve  either  monopoly  or  risk. — By  superior 
wit  and  by  strength  of  will  it  may  be  possible  to  buy  the  essentials 
of  production  at  a  price  below  the  market,  while  selling  at  prices 
based  on  the  full  market  costs,  thus  making  extraordinary  profits. 
Smuggling  goods  and  then  selling  in  a  market  where  prices  depend 
on  competition  of  duty  paid  goods;  “ moonshining”  whiskey  and 

groups.  Professor  Knight  has  summarized  the  evidence  and  the  opinions  of  lead¬ 
ing  economists  (Risk,  Uncertainty,  and  Profit,  pp.  364-66).  He  concludes  that 
profit  as  a  whole  is  negative.  For  a  fuller  summary  of  the  scanty  evidence, 
cf.  Porte,  Entrepreneurs  et  Profits  industriels,  pp  182-215. 

1  It  should  be  noted  that  in  strict  logic  the  return  which  accrues  to  the  owner 
of  a  monopoly,  after  the  value  of  his  opportunity  has  been  definitely  established,  is 
really  a  part  of  his  interest,  not  his  profit.  Once  the  amount  is  known  wrhich  can 
be  gotten  out  of,  for  instance,  a  patent,  the  patent  itself  has  a  value  which  capitalizes 
that  return,  and  the  return  becomes  interest  on  that  capitalized  value.  The 
profit,  which  comprises  the  whole  capitalized  value  of  the  patent,  minus  the  cost 
of  obtaining  and  developing  it,  arose  at  the  time  the  value  attached  itself  to  the 
patent,  that  is,  at  the  time  uncertainty  passed  into  certainty.  (Indeed  it  accrued 
in  part  before  that,  for  as  soon  as  it  becomes  highly  probable  that  the  patent  will 
have  value,  it  acquires  a  value  which  discounts  that  probability.)  So  with  other 
cases — the  return  from  a  monopoly  of  certain  quality  of  land  is,  after  all,  only  the 
rent  of  that  land,  no  different  in  character  from  any  other  rent.  Profit  arises  when 
the  income  producing  power  of  the  land  is  increased  by  the  formation  of  the  monop¬ 
oly,  not  when  the  higher  rent  is  collected  afterward. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


43 


selling  in  a  market  where  the  tax  is  a  main  element  in  the  market 
price,  are  examples.  “  Outbargaining  ”  labor  or  shrewdness  in  securing 
capital  on  favorable  terms  works  out  likewise.  There  does  not  seem, 
however,  to  be  any  necessity  for  erecting  these  gains  into  a  distinct 
distributive  share  or  regarding  them  as  exceptional.  The  question 
is  always,  not  “What  is  the  specific  source  of  profit?”  but  “Why 
does  not  the  competition  of  other  managers  destroy  the  profit  in 
exploiting  that  source?”  The  cases  cited  all  seem  to  resolve  them¬ 
selves  into  cases  where  competition  is  reduced  on  account  of  risk — as 
in  the  smuggling  industry,  or  into  special  aptitude  for  bargaining, 
which  must  be  recognized  in  determining  the  wages  of  the  bargainer, 
or  into  some  form  of  monopoly.  Frequently,  for  example,  a  local 
group  of  laborers  may  be  exploited  because  only  one  opportunity 
for  employment  is  accessible  to  them;  the  opportunity  to  profit  by 
such  a  situation  is  a  simple  case  of  monopoly  of  location. 

Risk  and  control  are  closely  associated. — In  the  preceding  discussion 
the  effect  of  risk  on  profit  and  on  business  organization  has  been  dis¬ 
cussed  on  the  assumption  that  the  two  functions  of  carrying  risk  and 
appropriating  profit  are  associated  with  the  exercise  of  control.  The 
combination  of  these  three  elements  is  the  root  of  the  present  system 
of  industry,  and  is  commonly  referred  to  as  the  right  of  private  prop¬ 
erty.  Some  of  the  social  results  of  this  combination  and  some  of  the 
ways  in  which  the  traditional  relationship  of  its  elements  are  being 
modified  are  discussed  in  chapter  xviii;  our  present  interest  is  to  note 
that  the  dominant  figure  in  present-day  industrial  and  commercial 
organization,  the  business  man,  owner-manager,  or  entrepreneur,  as 
he  is  variously  designated,  owes  his  position  to  the  supposed  advan¬ 
tages  of  vesting  control  in  those  who  are  financially  able  and  are 
willing  to  assume  the  risks  of  industry  and  the  responsibilities  of 
control  for  the  sake  of  an  opportunity  to  reap  a  more  or  less  uncertain 
reward  in  the  form  of  profit.  We  must  now  consider  some  of  the  quali¬ 
fications  for  successful  entrepreneurship. 

Certain  mental  attitudes  and  characteristics  are  necessary  for  adminis¬ 
tration  and  operate  more  or  less  crudely  to  select  the  individuals  on 
whom  responsibilities  of  business  shall  fall.  Without  attempting  an 
exhaustive  survey,  attention  may  be  directed  to  four  of  the  qualifica¬ 
tions  which  seem  to  be  most  directly  significant  in  the  selection  of 
business  managers.  The  first  is  business  judgment ,  the  second  is 
willingness  to  incur  risky  the  third  is  open-mindedness ,  the  fourth  is 
decision. 


44 


RISK  AND  RISK-BEARING 


All  these  qualities  have  to  do  with  one’s  attitude  toward  uncer¬ 
tainty.  By  judgment  we  mean  here  simply  the  ability  to  weigh  the 
known  elements  in  a  situation  and  determine  the  most  probable  situa¬ 
tion  with  respect  to  the  unknown.  Willingness  to  incur  risk  involves 
several  characteristics.  A  large  element  in  it  is  confidence  in  one’s 
own  judgment.  This  is  something  quite  distinct  from  the  ability  to 
form  a  correct  judgment.  As  Professor  Knight  says: 

....  There  is  diversity  in  conduct  in  situations  involving  uncertainty 
due  to  differences  in  the  amount  of  confidence  which  individuals  feel  in  their 
judgments  when  formed  in  their  powers  of  execution;  this  degree  of  con¬ 
fidence  is  in  large  measure  independent  of  the  “true  value”  of  the  judgments 

and  powers  themselves . It  is  a  familiar  fact  that  some  individuals 

want  to  be  sure  and  will  hardly  “take  chances”  at  all,  while  others  like  to 
work  on  original  hypotheses  and  seem  to  prefer  rather  than  shun  uncer¬ 
tainty.  It  is  common  to  see  people  act  on  assumptions  in  ways  which  their 
own  opinions  of  the  value  of  the  assumption  does  not  warrant;  there  is  a 
disposition  to  “trust  in  one’s  luck.”1 

Next  to  business  judgment  this  quality  of  confidence  in  and  willing¬ 
ness  to  act  on  one’s  best  judgment  where  certainty  is  absent  seems  to 
be  the  most  decisive  factor  in  determining  whether  one  shall  be  among 
those  who  occupy  positions  of  responsibility — indeed,  so  far  as  the 
choice  of  managers  is  concerned  this  factor  of  willingness  to  accept 
responsibility  is  perhaps  more  important  than  the  ability  to  form 
correct  judgments,  though  less  important  in  determining  the  manager’s 
success.  The  other  two  qualifications  for  dealing  effectively  with 
risk,  decision  and  open-mindedness,  may  seem  at  first  to  be  incon¬ 
sistent  with  one  another,  but  they  are  not.  By  open-mindedness  we 
mean  the  ability  and  willingness  to  change  our  decision  or  opinion 
as  soon  as  the  appearance  of  new  evidence  makes  it  appear  that  our 
former  position  was  wrong;  by  decision  the  ability  and  will  to  stick 
to  a  judgment  once  formed  until  such  reason  for  change  has  actually 
appeared.  Efficiency  in  business  management,  as  in  most  responsible 
tasks,  requires  that  one  steer  a  middle  course  between  two  extremes. 
On  the  one  hand,  we  have  the  vacillator,  the  wobbly-minded  man 
who,  having  chosen  one  line  of  policy  on  a  doubtful  issue,  cannot 
forget  the  alternative  and  is  constantly  reopening  the  issue  and  debat¬ 
ing  the  question  over  without  any  new  evidence  on  which  to  decide. 
At  the  other  extreme  we  have  the  “bullhead,”  the  man  who,  having 
chosen  an  alternative,  sticks  to  it  with  obstinacy,  refusing  to  be 

1  F.  H.  Knight,  Risk,  Uncertainty,  and.  Profit,  p.  242. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


45 


influenced  by  new  evidence  which  may  make  the  grounds  of  his 
original  choice  no  longer  valid.  There  are  none  so  blind  as  those  who 
will  not  see. 

Of  these  qualities  only  the  first,  business  judgment ,  needs  more 
extended  discussion.  As  indicated  above,  judgment  means  the  ability 
to  form  a  valuable  conclusion  in  a  case  where  the  evkience  does  not 
suffice  to  establish  certainty.  But  not  all  cases  of  uncertainty  call  for 
the  exercise  of  judgment.  The  determining  factor  is  not  the  presence 
of  uncertainty  but  the  character  of  the  uncertainty,  that  is,  the  exact¬ 
ness  with  which  the  degree  of  probability  is  known. 

Estimates  of  probability  fall  roughly  into  three  classes.1  There 
are,  first,  a  few  cases  where  a  quite  definite  mathematical  estimate  of 
probability  can  be  reached,  as,  for  instance,  that  a  result  will  be  of  one 
character  seven  times  out  of  a  hundred,  of  another  character  ninety- 
three  times.  Many  gambling  transactions  are  of  this  sort,  but 
illustrations  are  rare  in  ordinary  business.  The  Goodyear  Company, 
in  1921,  issued  a  series  of  8  per  cent  bonds,  one-fortieth  of  which, 
drawn  by  lot,  are  to  be  paid  at  $120  per  $100  bond  every  six  months 
for  twenty  years.  It  is  clear  that  the  probability  of  an  investor’s 
securing  a  20  per  cent  bonus  for  the  use  of  his  money  for  six  months, 
twelve  months^  or  any  other  definite  period  can  be  figured  math¬ 
ematically,  and  Che  speculative  value  of  this  chance  can  be  computed 
with  corresponding  precision.  No  “judgment”  enters  into  this 
calculation. 

A  second  and  larger  class  of  cases  affords  what  may  be  called  a 
statistical  basis  for  action.  These  are  cases  where  no  uniformity 
of  results  could  be  predicted  from  the  nature  of  the  case,  but  study 
of  past  results  shows  that  uniformities  have  appeared  with  such 
persistency  that  we  assume  they  will  continue  to  appear.  This  is  the 
justification  of  most  business  research,  as  distinguished  from  techno¬ 
logical  research.  The  merits  of  specific  selling  devices,  specific 
methods  of  wage  payment  or  organization  of  the  labor  force,  or  specific 
types  of  financial  instrument  cannot  be  judged  even  approximately 
by  a  single  case;  but  by  collecting,  organizing,  and  studying  a  mass 
of  representative  cases  results  of  great  accuracy  can  be  obtained. 
Here  again  if  the  evidence  is  sufficient  to  establish  the  degree  of  risk 
accurately,  as  it  is,  for  instance,  in  many  life  insurance  calculations, 
no  exercise  of  judgment  is  involved  in  the  estimate  of  probability. 

1  Cf.  Knight,  op.  cit.,  pp.  214-16,  224-26. 


40 


RISK  AND  RISK-BEARING 


Cases  of  uncertainty  where  neither  the  mathematical  nor  the 
statistical  basis  of  determining  probability  is  available  call  for  the 
exercise  of  what  we  call  “judgment.” 

These  are  cases  where  the  events  to  be  feared  are  so  rare,  or  the 
difficulty  of  forming  homogeneous  classes  among  them  as  a  basis  for 
statistical  generalization  is  so  great,  that  there  is  no  adequate  basis 
of  experience  for  judging  whether  they  will  take  place,  or  what  is 
the  probability  of  their  taking  place.  Thus,  while  the  probability 
that  a  given  individual  chosen  at  random  is  a  thief  might  be  tested 
statistically,  the  probability  that  a  certain  known  individual  is  a  thief 
is  often  quite  unattainable.  His  early  training,  his  beliefs  and  habits, 
his  family  responsibilities,  his  age,  and  a  hundred  other  things  have 
to  be  weighed,  and  there  are  not  enough  people  who  are  alike  in  all 
these  ways  to  afford  a  basis  for  a  statistical  study.  The  judgment  of 
a  good  student  of  human  nature  on  the  question,  nevertheless,  has  a 
greater  value  than  that  of  a  poor  student,  though  either  may  be  wrong 
and  either  may  be  right. 

The  method  by  which  these  cases  are  handled,  in  the  author’s 
opinion,  is  in  essence  a  very  crude  application  of  the  statistical  method.1 
That  is  merely  another  way  of  saying  that  our  judgments,  if  if  ey  have 
any  value  at  all,  are  based  invariably  on  some  sort  of  experience  with 
similar  cases,  either  our  own  experience  or  that  of  others.  The  cases 
from  which  we  judge  may  be  too  few  to  lend  themselves  to  statistical 
tabulation,  or  too  widely  different  for  comparison,  but  if  we  use  them 
at  all  it  must  be  through  a  crude,  perhaps  unconscious,  application  of 
what  is  essentially  the  same  process  as  is  employed  in  the  statistical 
method.  The  difference  between  good  judgment  and  bad  judgment 
resolves  itself  into  (i)  a  difference  in  the  amount  of  data  made  available 
by  personal  experience  or  by  education,  (2)  the  ability  to  classify  that 
experience  so  that  only  the  relevant  items  enter  into  the  judgment, 
and  (3)  the  ability  to  give  proper  relative  weight  to  the  items  which 
make  it  up. 

Of  these  the  last  is  the  most  difficult.  The  tendency  is  (1)  to 
overvalue  one’s  own  experience  in  contrast  to  that  of  others,  (2)  to 
overvalue  the  evidence  which  points  to  a  conclusion  coincident  with 
our  own  desires  or  interests,  and  (3)  to  overvalue  the  recent  experience 
contrasted  with  that  which  is  less  fresh  in  our  minds.  To  overcome 
these  tendencies  is  to  gain  immensely  in  skill  at  forming  judgments. 
And  no  one  should  feel  chagrin  if,  having  taken  into  consideration  all 

*  See  Note  1,  at  end  of  chapter  ii. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


47 


the  available  data  and  applied  his  most  careful  judgment,  the  event 
proves  him  to  have  been  in  the  wrong.  No  excellence  of  judgment  can 
eliminate  the  sphere  of  uncertainty;  it  can  only  tell  us  what  is  most 
probable.  If  the  improbable  happens,  the  judgment  of  the  reckless 
plunger  who  foretold  it  is  not  thereby  vindicated  nor  that  of  the 
careful  student  discredited.  Only  average  results  over  a  period  of  time 
can  furnish  a  test  of  skill.  Herodotus  states  the  point  aptly  thus: 

There  is  nothing  more  profitable  for  a  man  than  to  take  good  counsel 
with  himself;  for  even  if  the  event  turns  out  contrary  to  one’s  hope,  still 
one’s  decision  was  right,  even  though  fortune  has  made  it  of  no  effect: 
whereas  if  a  man  acts  contrary  to  good  counsel,  although  by  luck  he  gets 
what  he  had  no  right  to  expect,  his  decision  was  not  any  the  less  foolish.1 

A  more  detailed  survey  of  what  is  implied  in  the  formation  of  a 
business  judgment  is  given  by  a  psychologist  in  the  following  terms: 

The  conception  that  business  acumen  is  an  indefinable,  intangible  some¬ 
thing,  outside  the  realm  of  educability,  is  widely  held.  Nevertheless, 
psychologists  have  long  insisted  that  intellectual  insight  and  ability,  whether 
in  business  or  in  anything  else,  are  the  products  of  perfectly  definite  causes, 
in  part  hereditary,  but  in  part  acquired,  and  hence,  presumably,  susceptible 
in  some  degree  to  discipline.  Educators  have  long  prescribed  practical 
methods  for  training  reasoning  ability  in  school.  There  would  seem,  there¬ 
fore,  to  be  no  good  reason  why  schools  of  business  administration  should 
not  definitely  avow  as  one  primary  aim  the  cultivation  of  ability  to  make 
sound  business  judgments,  even  granting  that  it  may  require  actual  business 
experience  to  develop  that  ability  to  its  maximum  degree. 

Business  judgment  differs  from  judgment  in  other  fields  only  in  the 
materials  with  which  it  is  concerned — business  problems  and  business  facts— 
and  in  certain  minor  details  consequent  upon  the  peculiar  nature  of  those 
materials.  In  its  psychological  mechanisms  it  is  not  fundamentally  unlike 
scientific  method,  or  legal  reasoning,  or  reflective  thinking  in  any  other 
field;  although  the  frequent  short-circuiting  or  condensing  of  the  process, 
made  possible  through  long  practice  and  through  familiarity  with  a  definite 
field,  into  what  has  sometimes  been  called  “practical  judgment,”  often 
obscures  some  of  the  component  factors.  Judgment,  or  reasoning,  or 
reflective  thinking  (whmh  terms,  for  our  purposes,  we  may  regard  as  synony¬ 
mous)  may  be  described  as  essentially  a  complicated  kind  of  behavior 
by  means  of  which  the  individual  adjusts  himself  to  new  problems  pre¬ 
sented  by  an  ever  changing  physical  and  social  environment;  problems 
which  the  ready-made  adjustment  mechanisms  of  instinct,  habit,  and 
memory  are  incapable  of  solving.  Reasoning  is  made  possible  by  the  reor¬ 
ganization  and  re-utilization  of  the  element  of  previous  experience  in  new 

1  Quoted  in  Keynes,  A  Treatise  on  Probability ,  p.  307. 


48 


RISK  AND  RISK-BEARING 


forms.  It  is  no  unique  operation;  it  involves  the  same  mechanisms  of 
associative  recall  and  discrimination  as  the  simpler  operations  of  percep¬ 
tion,  habit,  and  memory,  although  on  a  somewhat  more  elaborate  scale, 
and  is  ordinarily  marked  by  greater  hesitancy  and  conscious  purposiveness. 
The  mental  content  in  which  these  mechanisms  find  embodiment  varies  with 
the  nature  of  the  materials  and  the  habits  of  the  individual  thinker.  It  may 
take  the  form  of  vocal  or  silent  speech  symbols,  mental  imagery  of  various 
sorts  (visual,  auditory,  or  motor,  verbal,  or  concrete),  or  incipient— or 
even  overt— gestures,  impulses,  and  attitudes,  although  the  modern  psy¬ 
chologist  is  inclined  to  regard  their  precise  character  as  of  less  significance 
than  the  use  made  of  them. 

Reasoning  activities  vary  widely,  of  course,  in  scope  and  complexity. 
An  “act  of  business  judgment”  may  denote  anything  from  an  instantaneous 
sizing-up  of  and  acting  on  a  relatively  simple  situation,  to  the  involved 
investigations  and  prolonged  deliberation  leading  up  to  a  momentous  bus¬ 
iness  decision  or  the  adoption  of  far-reaching  business  policies.  Sometimes 
the  basic  data  of  the  judgment  are  definite  and  complete;  sometimes  so 
obscure  that  a  judgment  is  almost  a  leap  in  the  dark,  and  even  the  shrewd 
executive  cannot  put  his  finger  on  the  specific  factors  which  determine  his 
decision.  But  in  all  such  acts  we  find,  explicit  or  implicit,  common  factors 
and  operations.  Seldom  is  it  possible  to  trace  these  as  temporally  distinct 
and  successive  stages,  so  varied  are  the  modes  in  which  they  may  be  sub¬ 
ordinated,  merged,  reversed,  and  repeated.  Nevertheless,  we  may  con¬ 
veniently  take  as  a  point  of  departure  for  our  search  for  ways  of  training 
judgment  five  stages  or  elements,  corresponding  in  the  main  to  those  “steps” 
which  Dewey1  has  made  familiar  to  students  of  education. 

1.  A  felt  difficulty 

2.  Its  location  and  definition 

3.  Suggestion  of  possible  solutions 

4.  Their  elaboration  and  evaluation 

5.  Belief,  decision,  action 

Let  us  examine  these  factors  in  greater  detail,  to  ascertain  what  sugges¬ 
tions  they  may  afford  for  our  problem  of  training. 

1.  A  felt  difficulty. — The  indispensable  precondition  of  all  thinking  is 
something  to  think  about,  a  problem  too  complex  or  too  novel  to  yield  to 
such  simpler  and  less  burdensome  methods  of  attack  as  instincts,  habit,  or 
memory.  It  may  be  either  an  intellectual  or  a  practical  difficulty,  present 
or  anticipated.  Such  a  predicament  serves  as  the  stimulus  for  thinking, 
and  determines  the  direction  thought  shall  take.  “Use  your  head!  Think 
about  it!”  is  the  most  futile — yet  by  no  means  the  most  infrequent — advice 
a  teacher  ever  gives  a  stupid  pupil  who  can  see  no  problem  about  which  to 
think — other  than  the  eminently  practical  problem  of  getting  the  teacher 

1  John  Dewey,  IIow  We  Think ,  chap  vi.  (Boston,  1910.) 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


49 


to  “lay  off  him.”  Recognition  of  this  fact  has  led  to  the  increasing  vogue 
of  the  “project-method”  or  “problem-method”  or  “case-method”  of 
organizing  educational  procedure. 

The  business  man’s  problem  may  perhaps  assume  the  form  of  an  emer¬ 
gency  demanding  action,  but  no  action  suggesting  itself;  or  a  suggestion 
of  doubtful  merit  may  come  to  mind;  or  two  or  more  possible  courses  of 
action  may  suggest  themselves,  necessitating  deliberation  and  choice.  If, 
as  often  happens,  the  problem  makes  its  first  appearance  in  very  definite 
form,  the  second  and  perhaps  the  third  of  the  stages  enumerated  may  be 
omitted — or  rather,  condensed  into  the  first,  in  the  way  previously  men¬ 
tioned.  The  task  then  becomes  one  of  weighing  and  evaluating  these 
suggestions.  But  sometimes  the  situation  is  so  involved  in  character  that 
its  key  is  not  apparent,  and  the  second  step  mentioned,  that  of  defining  the 
problem  and  locating  the  difficulty,  becomes  the  immediate  task. 

2.  Defining  the  problem. — This  is  essentially  a  matter  of  analyzing  the 
situation  into  its  factors,  significant  and  non-significant.  Thus,  a  slump  in 
sales  in  a  given  territory  may  conceivably  be  due  to  any  of  a  considerable 
number  of  factors,  and  a  large  part  of  the  task  of  relieving  this  particular 
difficulty  consists  in  analyzing  the  situation  into  its  factors,  geographical, 
financial,  personal,  social,  political,  etc.,  and  determining  which  are  signifi¬ 
cant  and  to  what  extent.  Only  then  can  one  look  for  an  adequate  solution 
to  suggest  itself.  The  problem  may,  on  analysis,  define  itself  as  essentially 
a  problem  of  (a)  putting  in  more  efficient  salesmen;  ( b )  meeting  prices  or 
terms  of  a  local  competitor;  (c)  improving  transportation  or  delivery  condi¬ 
tions;  ( d )  counteracting  harmful  propaganda;  (e)  making  connections  with 
new  dealers;  (f)  stimulating  present  dealers  to  greater  efforts — or  something 
else.  One  or  another  of  these,  in  turn,  may  call  for  still  further  definition. 

It  will  be  evident  that  only  one  who  has  a  thorough  familiarity  with 
the  subject-matter  to  which  the  problem  relates  can  tell  at  a  glance  which 
factors  are  significant  and  which  are  not.  We  cannot  insist  too  strongly 
that  no  efficient  thinking  about  any  problem  can  be  done  without  a  knowledge 
of  the  facts  in  the  case.  Contrary  to  a  notion  that  is  still  altogether  too 
popular,  reasoning  is  no  empty,  formal,  logical  gymnastic,  in  which  one  can 
exercise  himself  into  expertness  without  regard  to  the  peculiar  nature  of  the 
materials  involved.  No  matter  how  good  a  thinker  a  man  may  be  in  his 
own  field,  he  can  never  carry  over  ioo  per  cent  thinking  efficiency  to  a  field 
in  which  he  is  not  at  home.  True,  his  previous  training  in  thinking  may  be 
of  assistance  to  him  in  acquiring  familiarity  with  a  new  body  of  material, 
in  mastering  the  strange  viewpoints,  terms,  principles,  and  technique;  but 
only  actual  mastery  of  the  raw  materials  can  make  possible  good  judgment 
about  any  sort  of  problem.  We  see  daily  illustrations  of  foolish  and  incom¬ 
petent  judgments  uttered  by  men  who  are  experts  in  their  own  lines,  but 
whose  opinions,  when  they  venture  into  territory  filled  with  unfamiliar 
facts,  principles,  and  technique,  are  not  only  valueless  but  indeed  socially 


5o 


RISK  AND  RISK-BEARING 


injurious,  simply  because  their  susceptible  readers  fail  to  make  this  funda¬ 
mental  distinction. 

During  this  analytic  stage  a  sifting  process  has  been  going  on.  A  host 
of  irrelevant  details,  offering  no  promise  of  help,  have  quietly  dropped  out 
of  sight.  Simultaneously,  certain  others  have  proved  suggestive,  pointing 
out  hopeful  lines  of  inquiry,  and  rising  to  positions  of  central  importance  in 
dominating  thought  and  determining  the  direction  it  shall  take.  So  we 
reach  the  third  stage,  that  of  suggestions  of  solutions. 

3.  Suggestion  of  solutions. — Suggestion  or  association  is  a  fundamental 
psychological  principle,  basic  in  all  habit  and  memory.  We  recall  a  thing 
only  when  an  associate,  sensory  or  ideational,  is  at  hand  to  suggest  it;  in 
the  absence  of  such  stimulus  we  are  helpless.  We  can,  however,  actively 
aid  the  recall  process  by  assembling  before  us  all  available  stimuli,  in  the 
hope  that  one  or  another  will  have  retained  a  sufficiently  strong  connection 
to  suggest  the  thing  we  are  seeking.  Now  an  analysis  of  any  problem  does 
just  this:  it  brings  out  and  impresses  on  us  certain  vitally  significant  facts 
to  which  we  must  look  to  suggest  the  way  out.  These  serve  to  set  limits 
to  the  range  of  “trials  and  accidental  successes ”  which  play  so  central  a 
role  in  all  problem-solving,  whether  on  motor  or  ideational  levels.  If  we 
have  had  previous  experiences  of  the  particular  type  to  which  our  problem 
belongs,  such  associations  will  naturally  have  been  established,  and  sugges¬ 
tion  will  occur  actively. 

Here  again  is  evident  the  vital  necessity  of  a  background  of  knowledge. 
The  business  man  confronted  with  a  problem  of  a  sort  entirely  foreign  to 
his  previous  experience  feels  helpless,  because  absence  of  associations  gives 
him  no  clue  to  the  way  out.  Mistakes  of  judgment  are  often  directly  trace¬ 
able  to  inadequate  knowledge  and  consequent  insufficiency  of  possible 
suggestions,  or  to  inadequate  appreciation  of  the  implications  of  such 
suggestions  as  do  arise.  Probably  the  most  common  of  all  logical  fallacies 
is  overhasty  generalization.  A  single  experience,  or  a  striking  occurrence, 
is  elevated  to  the  dignity  of  a  general  truth  and  applied  indiscriminately  to 
all  sorts  of  situations,  usually  with  disastrous  results.  Business  men  fail, 
more  often  from  incapacity  than  for  any  other  reason,  and  incapacity  usually 
means  ignorance  of  things  one  should  know  about  his  own  business.  On 
the  other  hand,  the  leader  in  the  financial  and  industrial  world  is  not  infre¬ 
quently  a  man  of  remarkably  wide  information  concerning  matters  psy¬ 
chological,  social,  political,  geographical,  historical,  and  scientific,  which  to 
his  smaller-minded  contemporary  seem  irrelevant  and  useless.  Neverthe¬ 
less,  it  is  just  this  rich  background  that  suggests  to  him  the  probable  effects 
upon  general  business  conditions,  and  hence  upon  his  own  affairs,  of  influ¬ 
ences  apparently  remote,  and  yet  real,  and  thus  enables  him  to  prepare  for 
future  contingencies.  Those  business  men  who  were  hit  hardest  by  the 
post-war  depression  were,  in  many  cases,  those  who  a  few  years  before  knew 
only  that  the  way  to  greater  profits  was  by  buying  larger  stocks  on  rising 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


51 


markets,  but  who  did  not  have  that  larger  knowledge  of  social  and  economic 
conditions,  past  and  present,  which  would  have  warned  them  of  what  must 
inevitably  follow. 

Let  us  recall  once  more  that  familiarity  and  practice  make  for  short 
cuts  in  this  associative  process,  so  that  as  soon  as  the  problem  appears,  a 
course  of  action  may  suggest  itself,  even  though  we  do  not  stop  to  trace 
the  path — or  perhaps  not  even  be  able  to  do  so  if  we  try — which  logically 
leads  from  the  one  to  the  other.  The  series,  “A-B-C-D-E,”  built  up  in 
the  past,  becomes  condensed  and  short-circuited  into  the  direct  association, 
“A-E.”  This  facility  in  practical  judgment  is  a  priceless  asset  to  the 
executive;  such  judgments  constitute  a  large  part  of  his  everyday  thinking. 
But  behind  his  quick  and  certain  judgments,  which  evoke  our  admiration, 
we  may  be  sure  there  lies  a  history  of  years  of  faithful,  often  tedious,  accumu¬ 
lation  of  intellectual  capital  and  rigid  discipline  in  its  use. 

Akin  to  these  practical  judgments  are  those  uncritical  and  unanalyzed 
impulses  which  we  call  “hunches”  or  “intuitions,”  and  which  play  a 
disproportionately  large  part  in  some  people’s  decisions.  Such  judgments 
differ  from  the  kind  we  have  been  describing  not  in  their  essential  elements 
but  simply  in  the  greater  obscurity  of  the  specific  factors,  both  in  the  objec¬ 
tive  situation  and  in  the  individual’s  personal  history,  which  stimulate 
the  suggestions  and  determine  the  decision,  and  hence  in  the  relatively 
greater  part  played  by  feeling  and  impulse.  Sometimes,  it  is  true,  a  man’s 
feelings  and  impulses  have  been  unwittingly  trained  by  long  experience,  so 
that  his  “hunches”  are  better  than  mere  lucky  guesses,  even  though  he 
be  incapable  of  making  the  self-analysis  that  would  bring  their  historical 
origins  to  light.  But  let  us  not  overlook  the  fact  of  our  proneness  to  remem¬ 
ber  and  overstress  our  fortunate  guesses,  and  to  forget  our  mistakes,  and 
so  to  develop  a  superstitious  reverence  for  our  “intuitions.”  In  spite  of 
their  occasional  inevitability,  it  is  unsafe  to  form  the  habit  of  substituting 
such  impulses  for  critical  judgments,  if  we  can  possibly  find  any  basis  for 
critical  judgments. 

If  the  operations  thus  far  described — discriminative  analysis  of  the 
problem,  and  associative  suggestion  of  solutions — have  sufficed  to  over¬ 
come  all  inhibitions  to  action  and  induce  that  attitude  of  readiness  to  act 
which  we  call  belief,  decision  and  action  follow  automatically.  If  not,  we 
proceed  to  seek  for  further  evidence  of  the  relative  practicability  of  our 
hypotheses.  This  constitutes  the  fourth  stage  of  our  schema — the  elabora¬ 
tion  and  evaluation  of  the  suggestions;  and  this  is  what  distinguishes  critical 
reasoning  and  sound  judgment  from  uncritical  opinion,  impulse,  or  fancy. 

4.  Elaboration  and  evaluation  of  solutions. — By  elaboration  is  meant  the 
consideration  of  such  consequences,  positive  or  negative,  agreeable  or 
disagreeable,  as  may  be  expected  to  follow  from  this  or  that  course  of  action. 
This  again  involves  associative  suggestion,  and  efficiency  in  doing  it 
depends  directly  on  whether  or  not  the  individual  has  sufficient  acquaintance 


52 


RISK  AND  RISK-BEARING 


with  the  facts  in  question  to  know  what  their  consequences  may  reasonably 
be  expected  to  be.  Some  of  this  knowledge  comes  from  study  or  reading; 
some  of  it  comes  from  first-hand  or  second-hand  experiences  with  people 
and  things.  To  a  large  extent,  the  implications  which  one  who  makes 
business  judgments  must  consider  are  social,  involving  an  understanding 
of  how  people  act,  individually  or  collectively.  When  we  consider  extending 
credit  to  a  man  we  want  to  know  about  his  past  career,  his  present  habits, 
his  future  purposes,  in  order  to  be  able  co  predict  the  probable  outcome  of 
our  venture.  When  we  consider  investing,  or  enlarging  our  business,  we 
are  anxious  to  know  how  “conditions”  will  be  in  a  year  or  two  years  or  five 
years,  which  means  simply  that  we  want  to  know  what  the  mass  of  buyers, 
sellers,  investors,  and  workers  are  likely  to  be  doing,  testing-out  of  the  hypo¬ 
thetical  conclusion  is  called  for.  We  may  test  hypotheses  in  various  ways. 
We  may  try  out  our  plan  experimentally  on  a  limited  scale  to  ascertain 
whether  it  will  work  as  we  expect.  Or  we  may  try  it  out  on  the  “reflective 
level”  by  testing  it  against  other  accepted  general  principles,  or  with  the 
testimony  of  competent  authorities,  books  or  persons,  on  similar  or  related 
problems;  or  wTe  may  submit  our  data,  methods,  and  conclusions  to  com¬ 
petent  critics  to  discover  possible  omissions  or  errors.  One  of  the  marks 
of  the  wise  business  man  is  his  judicious  choice  of  counselors. 

5.  Action—  After  the  problem  has  been  defined,  suggestions  for  its 
solution  reached,  elaborated,  and  evaluated,  one  of  two  things  happens. 
If  the  process  has  been  unsuccessful,  it  is  repeated  and  new  analyses  and 
solutions  attempted.  If  it  has  been  successful  and  the  attitude  of  belief 
has  been  induced,  the  final  stage,  that  of  action ,  takes  place.  The  con- 
summatory  act  need  not,  of  course,  follow  immediately.  The  direct  out¬ 
come  of  a  reasoned  business  decision  may  be  a  more  or  less  explicitly 
formulated  program  for  future  action.  If  the  decision  covers  a  whole  class 
of  anticipated  situations,  we  call  it  the  formulation  of  a  policy.  The  realiza¬ 
tion  of  these  conditions  then  automatically  brings  the  act  which 
consummates  the  process;  the  crucial  point  was  reached  and  passed  when 
the  act  of  decision  was  accomplished.  What  has  been  said  about  the  ever- 
imminent  dangers  of  hasty  generalization,  of  undue  susceptibility  to  emo¬ 
tional  bias,  of  the  urge  of  impulse  and  prejudice,  of  post-rationalization  of 
motives,  and  like  enemies  of  logical  thinking,  means  simply  that  a  critical 
attitude  is  no  less  essential  for  sound  business  judgment  than  for  sound 
scientific  judgment. 

To  develop  good  business  judgment,  then,  is  not  a  hopeless  undertaking. 
Indeed,  assuming  reasonably  good  quality  of  brain  stuff,  good  judgment  is 
acquired  by  a  student  in  no  other  way  than  through  training — that  is,  through 
practice  in  discovering  problems  to  think  about,  in  getting,  reflecting  on, 
and  working  over  the  indispensable  capital  of  knowledge,  in  analyzing 
problems  and  sifting  facts,  in  organizing  data  and  keeping  them  organized 
to  facilitate  suggestions,  in  guarding  against  too  hasty  generalizations  or 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


53 


emotional  bias,  in  maintaining  an  attitude  of  suspended  judgment,  in  criti¬ 
cally  verifying  hypothetical  conclusions.  And  to  train  him  in  doing  these 
things  is  a  primary  function  of  the  school  of  business.1 

NOTE  I 

UNMEASURABLE  RISK  AND  THE  NATURE  OE  JUDGMENT 

The  contrary  view  to  that  expressed  in  the  text,  page  46,  is  held  by 
Professor  Knight,  and  is  made  central  in  much  of  his  treatment  of  the  theory 
of  risk.  In  his  view,  cases  where  there  is  no  statistical  or  mathematical 
basis  for  determining  the  degree  of  probability  are  the  only  cases  of  true 
uncertainty,  and  the  decisions  in  which  they  figure  are  not  based  on  any¬ 
thing  comparable  to  the  statistical  method  at  all.  The  only  way  of  dealing 
with  these  risks  is  to  assume  them,  acting  on  the  hypothesis  which  is 
estimated  to  be  most  plausible.  The  making  of  such  an  estimate  he  seems 
to  regard  as  a  purely  reflex  act  of  consciousness,  concerning  which  nothing 
really  significant  can  be  said: 

The  mental  operations  by  which  ordinary  practical  decisions  are  made  are 
very  obscure,  and  it  is  a  matter  for  surprise  that  neither  logicians  nor  psychologists 
have  shown  much  interest  in  them.  Perhaps  (the  writer  is  inclined  to  this  view) 
it  is  because  there  is  really  very  little  to  say  about  the  subject.  Prophecy  seems  to 
be  a  good  deal  like  memory  itself,  on  which  it  is  based.  When  we  wish  to  think 
of  some  man’s  name,  or  recall  a  quotation  which  has  slipped  our  memory,  we  go 
to  work  to  do  it,  and  the  desired  idea  comes  to  mind,  often  when  we  are  thinking 
about  something  else,  or  else  it  does  not  come,  but  in  either  case  there  is  very  little 
that  we  can  tell  about  the  operation,  very  little  “technique.”  So  when  we  try 
to  decide  what  to  expect  in  a  certain  situation,  and  how  to  behave  ourselves  accord¬ 
ingly,  we  are  likely  to  do  a  lot  of  irrelevant  mental  rambling  and  the  first  thing  we 
know  we  find  that  we  have  made  up  our  minds,  that  our  course  of  action  is  settled. 
There  seems  very  little  meaning  in  what  has  gone  on  in  our  minds,  and  certainly  little 
kinship  with  the  formal  processes  of  logic  which  the  scientist  uses  in  an  investiga¬ 
tion.  We  contrast  the  two  processes  by  recognizing  that  the  former  is  not  reasoned 
knowledge,  but  “judgment,”  “common-sense,”  or  “intuition.”  There  is  doubtless 
some  analysis  of  a  crude  type  involved,  but  in  the  main  it  seems  that  we  “infer” 
largely  from  our  experience  of  the  past  as  a  whole,  somewhat  in  the  same  way 
that  we  deal  with  intrinsically  simple  (unanalyzable)  problems  like  estimating 
distances,  weights,  or  other  physical  magnitudes  when  measuring  instruments  are 
not  at  hand. 

We  know  that  estimates  or  judgments  are  “liable”  to  err.  Sometimes  a 
rough  determination  of  the  magnitude  of  this  “liability”  is  possible,  but  more 
generally  it  is  not.  In  general,  any  determination  of  the  value  of  an  estimate  must 

1  Adapted  by  permission  from  Forrest  A.  Kingsbury,  “Business  Judgment  and 
the  Business  Curriculum,”  Journal  of  Political  Economy  (June,  1922),  pp.  375-88. 
It  may  be  noted  that  the  term  “judgment”  is  used  in  this  selection  in  a  slightly 
broader  sense  than  that  in  which  the  author  has  used  it  above,  to  include  cases 
where  absolute  certainty  is  finally  attainable. 


54 


RISK  AND  RISK-BEARING 


be  secured  by  the  tabulation  of  instances  of  accuracy  and  inaccuracy  of  similar 
estimates,  thus  reducing  it  to  a  probability  of  the  statistical  type. 

The  theoretical  difference  between  the  probability  connected  with  a  mere 
estimate  and  that  involved  in  statistical  calculations  such  as  those  used  in  life 
insurance,  is  clearly  discernible.  Take  as  an  illustration  any  typical  business 
decision.  A  manufacturer  is  considering  the  advisability  of  making  a  large  com¬ 
mitment  in  increasing  the  capacity  of  his  works.  He  “figures”  more  or  less  on  the 
proposition,  taking  account  as  well  as  possible  of  the  various  factors  more  or  less 
susceptible  of  measurement,  but  the  final  result  is  an  “estimate”  of  the  probable 
outcome  of  any  proposed  course  of  action.  What  is  the  “probability”  of  error 
(strictly,  of  any  assigned  degree  of  error)  in  the  judgment  ?  It  is  manifestly  mean¬ 
ingless  to  speak  of  either  calculating  such  a  probability  a  priori  or  of  determining 
it  empirically  by  studying  a  large  number  of  instances. 

Yet  it  is  true,  and  the  fact  can  hardly  be  over-emphasized,  that  a  judgment  of 
probability  is  actually  made  in  such  cases.  The  business  man  himself  not  merely 
forms  the  best  estimate  he  can  of  the  outcome  of  his  actions,  but  he  is  likely  also 
to  estimate  the  probability  that  his  estimate  is  correct.  The  degree  of  “certainty” 
or  of  confidence  felt  in  the  conclusion  after  it  is  reached  cannot  be  ignored,  for  it  is 
of  the  greatest  practical  significance.  The  action  which  follows  upon  an  opinion 
depends  as  much  upon  the  amount  of  confidence  in  that  opinion  as  it  does  upon  the 
favorableness  of  the  opinion  itself.  The  ultimate  logic,  or  psychology,  of  these 
deliberations  is  obscure.  We  must  simply  fall  back  upon  a  “capacity”  in  the 
intelligent  animal  to  form  a  more  or  less  correct  judgment  about  things,  an  intuitive 
sense  of  values.  We  are  so  built  that  what  seems  to  us  reasonable  is  likely  to  be 
confirmed  by  experience,  or  we  could  not  live  in  the  world  at  all.1 

The  issue  here  raised  is  fundamental.  The  view  of  the  nature  of  busi¬ 
ness  judgment  just  quoted  is  in  harmony  with  Professor  Knight’s  view  of 
the  nature  of  these  cases  of  unmeasurable  uncertainty.  If  the  uncertainty 
we  cannot  measure  is  of  a  totally  different  character  from  that  which  we 
can  reduce  to  a  mathematical  ratio  by  statistical  surveys,  if  there  is  indeed 
no  objective  basis  for  an  opinion  of  probability,  it  must  be  conceded  that 
the  only  way  we  can  deal  with  it  is  by  a  pure  creative  act  of  intelligence, 
“an  intuitive  sense  of  values”  (or,  more  accurately,  a  recognition  of  truths 
yet  to  be  born). 

In  the  view  of  the  present  writer,  however,  such  a  hypothesis,  while 
hardly  capable  of  disproof,  ought  not  to  be  accepted  until  other  alterna¬ 
tives  have  been  found  untenable.  Reliance  on  an  intuitive  sense  of  values, 
as  a  means  of  prediction  of  occurrences  outside  our  own  spiritual  experience, 
is  practically  indistinguishable  from  sheer  blind  guesswork,  dependence  on 
which  is  indeed  psychologically  thinkable  but,  we  hope,  not  our  final 
and  only  resource  in  dealing  with  problems  of  uncertainty. 

Rather  it  appears  probable  that  the  cases  of  “statistical  probability” 
and  the  cases  of  “true  uncertainty”  are  essentially  alike,  differing  only  in 
the  amount  of  information  we  happen  to  have  at  hand  to  deal  with  them, 


1  Knight,  op.  cil.y  pp.  21 1,  225-57. 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 


55 


the  length  of  time  necessary  to  accumulate  a  line  of  cases  big  enough  to 
establish  a  statistical  frequency,  or  the  fineness  of  the  classification  we  are 
using.  All  applications  of  the  law  of  averages  rest  on  a  grouping  of  things, 
unlike  in  many  respects,  into  classes,  on  the  basis  of  certain  similarities; 
if  cases  nearly  alike  are  infrequent,  we  must  do  our  grouping  on  the  basis 
of  less  homogenous  classes.  If  the  classification  is  crude,  or  if  the  cases 
are  not  numerous,  the  statistical  method  loses  its  accuracy.  But  these 
cases  certainly  shade  off  into  Professor  Knight’s  “true  uncertainties”  by 
imperceptible  degrees,  the  margin  of  error  getting  larger  as  the  evidence 
grows  more  scanty. 

There  are,  indeed  questions  concerning  which  no  evidence  whatever 
exists,  but  it  does  not  appear  probable  that  the  human  mind  is  equipped 
in  any  way  to  grapple  with  them.  And  if  any  basis  for  judgment  does 
exist  there  seems  to  be  no  way  to  exercise  it  except  to  throw  our  cases  into 
crudely  formulated  “like  cases,”  and  form  an  opinion  on  the  basis  of  the 
preponderance  of  the  evidence.  That  the  process  is  largely  automatic 
and  unconscious  is  of  course  obvious. 

The  view  that  the  so-called  “true  uncertainties”  are  cases  which  would 
show  statistical  regularity,  if  a  sufficient  number  of  like  cases  were  available 
for  comparison,  is  confirmed  by  the  fact  noted  by  Professor  Knight1  that 
the  totally  unpredictable  cases  do  show  some  tendency  toward  regularity 
when  grouped  with  other  similarly  unpredictable  data. 

QUESTIONS 

1.  The  ultimate  effect  of  improvements  in  business  methods  is  usually  to 
lower  prices  to  consumers,  yet  society  depends  on  the  self-interest  of 
business  men,  through  profits,  to  secure  the  adoption  of  improvements. 
Is  this  rational? 

2.  Profit  is  sometimes  stated  to  be  a  compensation  for  the  “irksomeness”  of 
riskbearing.  Discuss. 

3.  Can  you  cite  cases  where  profit  is  collected  without  either  monopoly 
conditions  or  significant  risk,  a)  temporarily?  b )  permanently? 

4.  Outline  (a)  the  qualities  which  enable  one  best  to  become  a  business 
manager;  ( b )  those  which  fit  one  best  to  succeed  as  a  business  manager. 

5.  What  do  you  mean  by  “accepting  responsibility?”  Would  the  expres¬ 
sion  mean  anything  in  the  absence  of  uncertainty  concerning  the  out¬ 
come  of  one’s  decision  ? 

1  Op.  cit.,  p.  239. 


I 


CHAPTER  IV 


WAYS  OF  DEALING  WITH  RISK:  TRANSFER 
TO  SPECIALISTS — Continued 

Besides  the  general  system  of  organization  which  results  in  a 
transfer  of  risk  from  capitalists  and  laborers  to  business  enterprisers, 
specialization  has  produced  numerous  types  of  organization  to  which 
it  is  possible  to  transfer  certain  of  the  risks  of  business.  Indeed, 
specializing  in  risk-bearing  is  one  of  the  most  striking  phases  of  our 
modern  differentiation  of  functions  and  functionaries.  The  most  con¬ 
spicuous  illustration  is  of  course  the  insurance  company,  but  there  are 
a  great  many  others.  Corporate  suretyship,  guaranty  of  real-estate 
titles,  guaranteed  collection  services,  and  the  hedging  facilities  offered 
by  produce  exchanges  are  illustrations. 

The  assumption  of  risks  for  others  looks  at  first  like  an  extremely 
hazardous  way  of  building  an  income.  It  is  not  necessarily,  however, 
more  risky  than  other  forms  of  business  enterprise,  for  the  risk-bearer 
is  usually  better  able  to  carry  the  risk  than  is  the  one  from  whom  it 
is  removed.  This  superiority  may  be  due  to  superior  knowledge  of 
the  situation,  as  when  a  title-guaranty  company  investigates  a  real- 
estate  title,  satisfies  itself  that  there  is  no  real  risk,  and  then  guarantees 
the  validity  of  the  title.  The  owner  of  the  property  gets  rid  of  the 
risk  by  transfer,  the  guaranty  company  assumes  it,  but  reduces  it  to 
a  minimum  by  research. 

In  a  second  class  of  cases  the  risk  is  transferred  to  a  specialist 
who  is  able  to  reduce  it  by  prevention.  This  is  illustrated  when  an 
investment  bank  guarantees  the  sale  of  a  bond  issue,  knowing  that 
its  own  indorsement  will  assure  the  success  of  the  flotation,  or 
when  a  steam-boiler  insurance  company  issues  a  policy  to  protect  the 
owner  of  a  plant  and  then  furnishes  an  elaborate  and  efficient  inspec¬ 
tion  service  to  reduce  the  hazard  of  loss.  In  a  third  class  of  cases  the 
reduction  of  risk  arises  from  the  fact  that  the  specialist  who  assumes 
the  specific  risk  combines  it  with  a  great  number  of  others  and  so 
reduces  the  amount  of  uncertainty,  and  hence  the  amount  of  risk 
through  operation  of  the  law  of  large  numbers.  This  is  the  basic 
principle  of  most  forms  of  insurance. 


56 


WAYS  OF  DEALING  WITH  RISK:  SPECIALISTS 


57 


For  all  these  forms  of  enterprise  the  chief  hazard  is  not  the  hazard 
insured  against,  but  the  risk  of  failing  to  get  sufficient  business  to 
furnish  a  working  basis  for  the  law  of  large  numbers,  or  to  repay  the 
costs  of  organization. 

It  should  be  noted,  however,  that  in  all  these  cases  the  substitu¬ 
tion  of  certainty  for  uncertainty  effects  a  saving  of  indirect  losses 
resulting  from  the  event  insured  against,  even  though  the  direct  losses 
are  not  reduced  in  number.  Fire  insurance  affords  a  convenient 
illustration.  Suppose  that  in  the  space  of  five  years  on  an  average 
i  per  cent  of  buildings  of  a  certain  type  are  burned  and  that  the  cost 
of  selling  insurance,  keeping  track  of  the  business,  investigating 
claims,  etc.,  together  with  the  profits  of  the  insurance  company, 
brings  the  cost  of  insurance  on  such  buildings  up  to  2  per  cent.  Sup¬ 
pose  A  insures  and  B  refuses  to  do  so.  It  is  evident  that  in  the  long 
run  A  will  pay  out  twice  as  much  for  insurance  premiums  as  B  will 
lose  by  fires.  But  if  B  has  only  one  or  two  buildings,  the  “long  run” 
necessary  to  make  him  fairly  sure  of  this  saving  will  be  a  great  deal 
longer  than  his  lifetime.  Instead  of  saving  the  difference  between  the 
amount  of  the  premiums  and  the  average  or  normal  loss,  he  gambles 
for  the  saving  of  a  larger  amount.  If  he  is  lucky  enough  to  have 
no  serious  fires,  he  saves  the  whole  premium.  If  his  building  is 
destroyed,  he  probably  will  never  five  long  enough  to  save  the  amount 
lost  out  of  his  insurance  premiums.  Moreover,  if  he  has  his  whole 
capital  sunk  in  one  building  he  has  no  chance  to  save  any  of  the  loss 
in  this  way  until  he  has  accumulated  enough  to  put  up  another 
building.  If  the  building  is  used  for  business  purposes,  moreover, 
its  destruction  is  likely  to  mean  not  only  the  loss  of  the  value  of  the 
building,  but  also  the  loss  of  business,  good  will  of  customers,  etc. 
Part  of  this  loss  is  unavoidable,  but  an  insurance  policy  which  enables 
one  to  rebuild  quickly  or  to  pay  off  debts  which  have  been  secured  by 
the  building  may  enable  him  to  save  a  large  part  of  this  indirect  loss. 

One  of  the  most  important  risks  wdth  which  we  have  to  deal  is  that 
which  arises  from  the  uncertainty  of  the  length  of  human  life.  This 
takes  two  forms — the  risk  that  one  may  live  so  long  as  to  use  up  the 
funds  which  he  has  provided  to  support  himself  in  old  age  and  the 
risk  that  he  may  die  before  the  end  of  his  normal  working  life.  Each 
contingency  needs  to  be  provided  against. 

The  first  is  taken  care  of  in  large  part  by  the  method  of  reserves, 
the  individual  setting  aside  a  part  of  his  earnings  as  a  provision  for 
old  age,  a  larger  part  in  many  cases  than  would  be  necessary  if  the 


RISK  AND  RISK -BEARING 


length  of  life  were  known.  The  life  annuity  is  a  special  device  for 
taking  care  of  this  risk.  This  is  a  contract  whereby  an  insurance 
company  or  other  corporation  agrees  for  a  fixed  sum  to  pay  a  given 
individual  a  stipulated  income  so  long  as  he  lives.  For  one  who  will 
live  only  an  average  period,  the  contract  is  not  ordinarily  an  attractive 
investment,  but  it  relieves  him  of  the  risk  of  using  up  all  his  savings 
and  coming  to  want  because  of  an  unexpectedly  long  life.  The  pure 
endowment  is  another  contract  which  insures  against  a  risk  arising 
from  the  length  of  life.  It  is  similar  to  an  annuity  except  that  the 
person  taking  out  the  contract  pays  his  money  in  annual  instalments 
for  a  term  of  years,  and  at  the  end  of  that  time  receives  a  lump  sum. 
If  he  dies  within  the  stipulated  time,  nothing  is  paid  by  the  company. 
Such  contracts  have  been  used  in  Europe  by  parents  to  provide  for 
the  expense  of  higher  education  of  their  children,  or  to  provide  dowries 
for  daughters.  Endowment-life  policies  combine  pure  insurance  and 
pure  endowment  in  one  contract. 

The  second  type  of  risk  connected  with  human  life  is  the  risk  of 
death  before  one’s  normal  working  life  is  completed,  with  consequent 
loss  of  earnings.  The  way  which  this  risk  is  shifted  to  insurance 
companies  will  serve  as  an  illustration  of  what  we  mean  by  the  elimina¬ 
tion  of  risk  through  specialization  and  combination.  For  the  indi¬ 
vidual,  there  is  nothing  more  uncertain  than  the  duration  of  his  life. 
For  the  insurance  company,  on  the  other  hand,  the  insurance  contract 
involves  very  little  risk.  Which  of  the  insured  will  die  no  man  knows; 
how  many  will  die,  ii  the  number  of  insured  is  large,  can  be  predicted 
with  great  accuracy.  Hence  the  company  can  profitably  sell  the 
insurance  at  a  price  at  which  it  is  a  good  bargain  for  the  insured. 

Outside  the  fields  of  fire  and  life  insurance,  the  most  important 
branch  of  the  insurance  business  is  marine  insurance.  Newer  types 
which  are  gaining  rapidly  in  popularity  are  burglary,  plate  glass, 
automobile,  and  credit  insurance.  In  all  these  cases,  the  principle  is 
the  same.  If  a  business  has  a  large  enough  number  of  risks  and  if  the 
risks  are  independent  of  one  another,  it  is  likely  to  be  cheaper  not  to 
insure,  for  unless  the  insurance  company  receives  a  great  deal  more  in 
premiums  than  it  pays  out  for  losses  it  cannot  continue  to  do  business. 
A  railroad  company  need  not  insure  its  station  buildings,  and  a  large 
business  owning  many  buildings  with  plate-glass  windows  need  not 
insure  them  against  breakage.  The  amount  paid  out  in  premiums 
will  be  greater  than  the  amount  needed  to  replace  the  damage.  In 


WAYS  OF  DEALING  WITH  RISK:  SPECIALISTS 


59 


the  same  way,  a  large  number  of  small  risks  of  different  kinds  may  be 
allowed  to  offset  one  another.  Wherever  such  a  distribution  of  risk 
cannot  be  secured,  however,  assuming  that  the  expense  loading  and 
profits  of  insurance  companies  are  not  excessive,  all  insurable  risks 
should  be  insured  against,  for  the  insurance  company,  having  a  wider 
distribution  of  risk,  can  definitely  count  on  a  smaller  variation  in  the 
number  of  losses  than  can  any  one  individual,  and  hence  can  get  along 
with  smaller  reserves  withdrawn  from  active  business  use  to  guard 
against  the  impairment  of  working  capital. 

The  field  covered  by  insurance  companies,  however,  is  much 
narrower  than  the  field  of  risk  involved  in  carrying  on  business. 
For  a  risk  to  be  well  adapted  to  insurance  and  elimination  by  combina¬ 
tion,  twro  conditions  are  necessary.  There  must  be  available  for 
insurance  coverage  a  large  number  of  independent  risks,  and  the 
probability  of  the  occurrence  of  the  event  insured  against  must  be 
known  with  fair  accuracy.  If  the  first  condition  is  absent  the  insur¬ 
ance  is  speculative;  if  the  second  is  absent  it  is  impossible  to  determine 
a  fair  rate,  as  the  combination  of  risks  does  not  afford  knowledge 
as  to  the  total  losses  to  be  anticipated.  Insurance  under  either  of  these 
conditions  involves  simply  a  transfer  of  risk  from  one  individual  to 
another,  without  reduction,  and  is  speculative  in  character.  To  meet 
the  need  for  insurance  or  for  protection  against  various  types  of  loss 
where  no  statistics  are  available  from  which  to  calculate  the  expected 
loss,  or  where  no  proper  distribution  of  risk  can  be  obtained,  the  Lloyd’s 
type  of  speculative  insurance  has  been  developed.  In  this  type  of 
contract,  a  large  group  of  private  insurers  enter  into  a  contract  by 
which  they  agree  to  recompense  the  insured  for  his  loss  dividing  the 
cost  between  themselves.  For  example,  people  in  Washington  owning 
property  along  the  line  of  march  of  the  inaugural  procession  sometimes 
insure  themselves  against  loss  from  bad  weather  on  the  fourth  of  March 
through  the  London  Lloyd’s.  The  insurers  in  this  case  may  secure  a 
distribution  of  risk,  in  spite  of  the  fact  that  if  they  have  a  loss  on  one 
policy  they  will  have  a  loss  on  every  policy  of  this  type.  This  is  done 
by  diversifying  the  contracts.  If  the  individual  insurer  writes  many 
policies  and  none  are  large,  he  secures  a  combination  of  risks  which 
protects  him  against  excessive  loss.  But  there  is  a  large  speculative 
element  involved  in  the  fixing  of  the  premium  rates.  Protection 
against  drought  is  of  this  character.  So  long  as  such  policies  are 
written  to  cover  a  bona  fide  risk  and  not  for  speculation,  they  are  as 


6o 


RISK  AND  RISK-BEARING 


useful  as  any  other  type  of  insurance,  but  the  device  obviously  lends 
itself  admirably  to  gambling  and  is  often  used  for  that  purpose.1 
In  the  earlier  days  of  life  insurance,  it  was  permissible  for  anyone  to 
take  out  insurance  on  the  life  of  anyone  else,  and  policies  practically 
of  the  Lloyd’s  type,  on  the  lives  of  public  men  were  often  taken  out 
purely  for  gambling  purposes. 

Very  similar  to  the  speculative  type  of  insurance  is  the  practice 
of  hedging.  This  is  the  practice  of  making  two  contracts  at  about 
the  same  time  of  an  opposite,  though  corresponding,  nature — the  one 
in  the  trade  market  and  the  other  in  the  speculative  market.2  The 
same  possibility  of  using  a  contract  either  for  the  purpose  of  hedging 
a  legitimate  risk  or  for  the  purpose  of  creating  a  gambling  risk  which 
we  say  in  the  Lloyd’s  contracts  arises  in  connection  with  these  “future 
contracts”  on  the  produce  exchanges.  When  a  grain  merchant  sells 
a  future  contract  to  hedge  against  a  fall  in  prices  while  he  is  marketing 
his  purchases  of  cash  grain,  or  a  flour-miller  buys  a  future  contract 
to  protect  himself  against  loss  while  he  is  manufacturing  flour  which 
he  has  agreed  to  deliver,  they  are  securing  protection  against  a  definite 
risk  in  much  the  same  way  that  one  secures  protection  against  unknown 
hazard  through  Lloyd’s  policy,  but  in  both  cases  the  only  way  that  the 
insuring  or  hedging  individual  gets  rid  of  his  risk  is  by  transferring 
it  to  someone  else  who  assumes  it  as  a  speculation.  The  whole 
machinery  of  the  produce  exchange  finds  its  justification  in  the  facilities 
which  it  affords  for  carrying  on  certain  types  of  business  with  a  mini¬ 
mum  risk  and  consequently  at  a  minimum  cost.  There  is  no  question 
that  it  is  sound  business  policy  to  make  use  of  the  hedging  market 
wherever  a  hedging  contract  can  be  secured  on  reasonable  terms,  but 
the  existence  of  a  hedging  market  presupposes  the  existence  of  a 
group  of  speculators  who  are  taking  the  risk  off  the  business  man’s 
shoulders,  and  there  has  as  yet  been  found  no  way  to  keep  these 
contracts  from  being  bought  and  sold  in  a  purely  gambling  spirit. 

Another  way  of  transferring  risk  is  what  is  known  as  “contracting 
out,”  a  method  similar  to  hedging,  but  not  involving  the  use  of  a 
speculative  futures  market.  Contracting  out  may  be  explained 
briefly  as  follows: 

The  work  of  the  organized  exchanges  has  certain  sensational  elements, 
and  volumes  have  been  written  upon  these  exchanges  where  sentences  have 

1  For  fuller  discussion  cf.  chap.  xiv. 

2  S.  S.  Huebner,  “The  Functions  of  Produce  Exchanges,”  Annals  of  the  Ameri¬ 
can  Academy  of  Political  and  Social  Science ,  XXXVIII  (1911),  392.  For  fuller 
discussion,  cf.  chap.  xii. 


WAYS  OF  DEALING  WITH  RISK:  SPECIALISTS 


61 


not  been  written  upon  the  vastly  greater  volume  of  speculative  contracts 
entered  into  outside  the  limits  of  the  organized  exchange.  These  speculative 
contracts  are  so  well  known  that  a  simple  illustration  will  suffice.  I  decide 
to  build  a  house.  A  contractor  assumes  the  task.  He  then  proceeds  to 
make  sub-contracts  with  the  purveyors  of  lumber,  bricks,  and  other  mate¬ 
rials  to  the  effect  that  these  materials  shall  be  delivered  to  him  at  a  certain 
future  time  and  at  a  certain  price.  The  main  contractor  has  thus  con¬ 
tracted  himself  out  of  risk  with  reference  to  price  changes  in  these  materials. 

Our  contractor  has  thus  been  relieved  of  much  of  his  risk. 

The  foregoing  illustration  is  typical.  A  man  agrees  to  do  a  certain 
thing.  He  then  contracts  himself  out  of  certain  phases  of  the  risk  involved. 
True,  the  burden  is  merely  transferred  to  someone  else,  but  presumably 
this  someone  else  is  a  specialist,  and  therein  is  the  social  defense.1 

In  the  building  industry  and  in  some  lines  of  manufacturing,  it 
is  practicable  to  pass  on  in  this  way  the  risk  of  price  changes  in  nearly 
all  the  important  cost  items  except  labor;  this  latter  risk  the  manager 
must  ordinarily  himself  assume  if  he  contracts  in  advance  to  sell  his 
product  at  a  given  price.  During  the  war,  however,  it  was  not 
uncommon  for  building  contractors  to  rid  themselves  of  this  risk  by 
stipulations  that  the  contract  price  should  be  readjusted  in  case 
changes  in  wage  rates  should  occur  before  the  completion  of  the 
job. 

In  many  lines  of  commercial  and  manufacturing  enterprise,  risks 
can  be  passed  on  by  coupling  advance  sales  with  advance  purchases; 
in  other  lines,  the  risks  must  be  assumed  but  can  be  kept  at  a  minimum 
by  keeping  inventories  and  advance  orders  low.  Quick  turnovers 
give  relatively  little  chance  for  profit  or  loss  from  price  changes. 

It  is  usually  the  case,  however,  that  at  some  point  in  the  chain 
of  successive  buyers  and  sellers  the  possibility  of  contracting  out  or 
coupling  purchases  and  sales  disappears.  Someone  must  assume 
the  risks;  the  fact  that  the  one  who  assumes  them  is  a  specialist 
means  that  he  has  superior  facilities  for  judging  the  situation,  if  a 
basis  for  judgment  exists,  but  it  also  means,  as  a  rule,  that  he  does  not 
secure  a  good  distribution  of  risks. 

QUESTIONS 

1.  Does  insurance  reduce  risks  or  does  it  transfer  risks  from  the  individual 
to  society  ? 

2.  Should  a  state  carry  insurance  on  its  buildings? 

1  Adapted  by  permission  from  L.  C.  Marshall,  Industrial  Society,  pp.  501-2. 


62 


RISK  AND  RISK-BEARING 


3.  B,  a  dealer,  has  500  automobiles  in  stock.  Should  he  insure  them? 

4.  Give  some  examples  of  cases  when  it  is  cheaper  to  run  risks  than  to 
avoid  them. 

5.  Should  the  amount  of  the  insurance  carried  on  buildings  depend  on 
their  cost  or  on  present  cost  of  replacing  them  ? 

6.  C  is  supported  by  the  income  from  his  wife’s  property  and  does  not 
work.  Should  his  life  be  insured?  Should  his  wife’s  life  be  insured 
in  his  favor  ? 


u 

CHAPTER  V 

UNCERTAINTY  AND  THE  BUSINESS  CYCLE 

One  direct  result  of  the  presence  of  uncertainty  in  economic 
affairs  is  of  such  general  interest  and  is  so  fundamental  to  an  under¬ 
standing  of  the  working  of  a  competitive  business  organization  as  to 
require  more  careful  study  than  we  have  found  it  necessary  to  give 
to  most  aspects  of  the  risk  problem.  This  is  the  tendency  of  produc¬ 
tion  in  certain  lines  to  exhibit  a  fairly  regular  alternation  of  excessive 
activity  and  stagnation.  Maladjustment  of  production  and  consump¬ 
tion  we  should  expect  to  find  as  a  result  of  the  presence  of  uncertainty 
in  the  calculations  of  producers,  but  the  presence  of  a  rhythm  of  over¬ 
production  and  underproduction  as  a  result  of  this  uncertainty  requires 
special  explanation. 

In  the  following  pages  will  be  presented,  first,  a  description  of  the 
phases  of  the  business  cycle  as  they  have  typically  shown  themselves 
in  recent  years,  and  second,  a  discussion  of  the  causes  of  the  phenomena 
described,  with  particular  reference  to  the  extent  to  which  the  cause 
is  found  in  the  existence  of  business  risk. 

The  stages  of  the  typical  business  cycle  are  generally  considered 
to  be  four:  depression,  improvement,  prosperity,  liquidation. 
Although  it  is  sometimes  impossible  to  state  accurately  the  time 
at  which  one  of  these  stages  merges  into  the  following  one,  the  classi¬ 
fication  is  convenient  and  we  shall  utilize  it  in  describing  the 
phenomena  of  the  cycle.  Let  us  start  our  description  with  a  period 
of  depression,  such  as  existed  in  the  United  States  in  1894,  in  1908, 
and  in  1921. 

Depression  is  characterized  by  low  production ,  low  prices ,  and  low 
profits. — The  most  conspicuous  fact  about  the  whole  industrial  and 
commercial  organization,  as  it  appears  at  such  a  time,  is  its  amazing 
inefficiency.  It  is  like  a  well-oiled  machine  stuck  on  a  “dead  center.” 
Mills  stand  idle,  mines  are  closed,  freight  cars  are  empty,  and  fleets 
rot  at  the  wharves.  The  falling  off  in  the  volume  of  physical  produc¬ 
tion  runs  in  some  industries  to  50  or  60  per  cent,  while  many  individual 
firms  completely  suspend  operations.  Different  lines  of  business  are 
very  differently  affected,  however.  At  the  one  extreme,  among  the 
major  industries,  stands  agriculture,  in  which  the  volume  of  production 

63 


04 


RISK  AND  RISK-BEARING 


is  usually  not  reduced  at  all.  Individual  farm  products  have  their 
own  cycle  of  overproduction  and  underproduction,  but  these  rarely 
correspond  to  the  cycle  of  general  business.1  Bakeries,  ice  plants, 
distributors  of  fresh  milk,  and  other  producers  of  perishables  expe¬ 
rience  a  very  slight  falling  off  in  their  volume  of  business.  On  the  other 
hand,  dealers  in  canned  foods  and  preserved  meats,  flour-millers,  and 
most  producers  of  staple  non-perishable  goods  experience  a  drastic 
reduction  in  the  demand  for  their  products.  Bituminous  coal  pro¬ 
duction  is  curtailed  much  more  than  anthracite.  Production  of  pig 
iron,  copper,  zinc,  and  other  industrial  metals  is  greatly  reduced.  The 
building  industry  is  likely  to  be  greatly  curtailed  in  its  operations  in 
the  early  stages  of  a  depression,  but  residence  and  public  construction 
pick  up  rapidly,  encouraged  by  the  lower  costs  of  materials  and  labor 
which  characterize  such  a  period.  Trade,  as  a  rule,  is  reduced  less 
than  manufacture  and  retail  trade  less  than  wholesale.  Prices  are 
low;  prices  of  raw  materials  lower  than  those  of  half -finished  products, 
and  those  of  finished  goods  relatively  the  highest. 

The  volume  of  unemployment  reaches  its  maximum,  as  a  rule, 
about  the  middle  of  a  depression,  though  generally  the  decline  in 
wages  lags  considerably  behind  the  decline  in  the  volume  of  business 
and  does  not  proceed  as  far.  The  efficiency  of  labor  is  high  for  three 
reasons:  first,  because  the  cutting  down  of  industrial  forces  has  taken 
the  form  of  a  weeding  out  of  the  least  efficient;  second,  because  the 
fear  of  unemployment  is  a  great  stimulus  to  the  efficiency  of  those 
who  remain  upon  the  pay-roll;  and  third,  because  many  laborers  who 
are  on  the  border  line  between  two  grades  of  skill  get  into  the  more 
skilled  class  in  periods  of  business  activity  and  drop  back  into  the 
less-skilled  class  when  business  is  dull,  thereby  increasing  the  average 
efficiency  of  both  groups.  Strikes  are  not  numerous,  though  some 
of  the  most  destructive  have  occurred  at  just  such  periods. 

The  decrease  in  the  volume  of  trade  and  manufacture  is  reflected 
in  the  reports  of  business  done  by  the  banks.  Bank  statements  indi¬ 
cate  a  position  of  great  strength,  loans  and  deposits  being  low  and 
reserve  ratios  high,  but  the  strength  is  not  as  great  as  it  appears,  for 
the  proportion  of  uncollectible  paper  held  is  at  a  maximum. 

Profits  in  most  lines  of  business  are  decreased  more  than  is  gross 
income.  Commercial  failures  are  numerous,  especially  in  the  earlier 
part  of  the  depression.  Interest  rates  are  low. 

1  For  illustrations  see  Warren,  Farm  M anagement,  pp.  83-90,  quoted  below, 
pp.  76-78. 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 


65 


Recovery  may  be  either  gradual  or  sudden. — The  transition  from 
depression  to  prosperity  is  typically  very  gradual,  at  least  in  the  earlier 
stages  of  improvement,  but  occasionally  it  is  startlingly  sudden. 
When  the  latter  condition  prevails,  the  recovery  will  invariably  be 
found  to  have  been  started  by  some  exceptional  circumstance,  such 
as  the  combination  of  good  crops  in  this  country  with  short  crops 
abroad  which  stimulated  business  in  1879,  or  the  rush  of  war  orders 
which  banished  depression  early  in  1915.  If  no  such  favorable  inci¬ 
dent  occurs,  the  depression  itself  gradually  engenders  conditions 
which  make  for  recovery,  but  the  recovery  in  these  cases  is  slow  and 
does  not  affect  the  whole  business  world  at  the  same  time.  Some 
industries  are  gaining  ground  while  others  are  still  going  backward, 
so  that  it  is  impossible  to  recognize  the  turning  point  until  it  has  been 
passed. 

Increase  of  production  usually  starts  at  points  where  it  has  been 
curtailed  most  sharply  on  account  of  excessive  stocks  which  have  been 
carried  over  from  the  preceding  period  -of  prosperity.  Production 
has  been  curtailed  below  even  the  low  rate  of  consumption  which  pre¬ 
vails  during  the  depression,  and  as  a  result  the  excess  is  worked  off. 
Then  new  stocks  of  goods  must  be  produced  to  satisfy  the  demand. 
Changes  in  fashion  and  the  appearance  of  new  kinds  of  consumption 
goods  also  sooner  or  later  stimulate  increase  of  production.  Most 
important  of  all,  in  several  cases,  has  been  the  revival  of  building  and 
of  railway  and  public  utility  construction.  Investments  of  this 
character  are  made  with  a  view  to  the  distant  future,  hence  the 
immediate  prospect  of  dull  business  may  be  offset  by  the  relative 
cheapness  of  materials  and  labor,  whereas  producers  of  goods  for  early 
consumption  must  be  governed  more  by  the  outlook  for  markets  in 
the  near  future  than  by  considerations  of  economy  in  the  costs  of 
production. 

Once  the  increase  in  business  activity  gets  under  way  it  is  likely 
to  radiate  with  increasing  rapidity.  If  building  industry  expands, 
brick,  cement,  and  lumber  interests  feel  the  effects  at  once;  steel, 
copper,  and  transportation,  a  little  later.  Each  of  these  passes  its 
growing  prosperity  to  others.  Later  still,  retail  buying  shows  some 
effect  of  the  increased  volume  of  employment.  No  single  enterprise 
is  self-sufficient;  each  is  influenced  by  the  fortunes  of  its  customers 
and  of  those  from  whom  it  buys. 

The  effects  of  the  increase  of  production  on  the  labor  market  and 
the  money  market  are  obvious.  Unemployment  decreases,  and  wages 


66 


RISK  AND  RISK-BEARING 


rise,  at  first  more  rapidly  than  the  cost  of  living,  then  as  prosperity 
develops  tend  to  lag  behind  until  the  eve  of  a  crisis,  when  they  begin 
again  to  run  ahead.  Bank  loans  increase,  but  interest  rates  are  slow 
to  follow  other  prices  upwrard.  Banking  is  one  of  the  businesses 
where  an  increase  in  customers’  demand,  coming  in  slack  times,  can 
be  taken  care  of  with  the  least  additional  expense,  hence  competition 
prevents  any  material  advance  in  rates  until  the  revival  has  run  a 
long  way. 

An  increase  in  business  activity  does  not  necessarily  carry  with  it 
an  immediate  advance  in  most  prices.  The  raw  material  markets 
are  very  sensitive  because  they  are  as  a  rule  “buyers’  markets.” 
There  is  very  little  organization  in  them  to  restrict  production  and 
control  prices,  consequently  prices  go  very  low  during  depression,  and 
the  resumption  of  competitive  buying  quickly  puts  them  up.  The 
case  of  most  manufactured  goods  is  different.  Their  prices  have 
usually  been  maintained  during  the  dull  period  to  some  extent  by 
curtailment  of  output,  and  manufacturers  come  into  the  revival  period 
with  idle  plant  capacity,  which  makes  it  possible  for  them  to  handle 
the  increased  volume  of  business  with  less  than  proportionate  increase 
in  expenditures.  Hence  competition  is  apt  to  be  keen  until  the 
expansion  of  business  has  proceeded  to  the  point  where  existing  plants 
are  booked  ahead  to  capacity,  and  prices  show  relatively  little  tend¬ 
ency  to  advance.  The  advances  in  prices  of  raw  materials  and  wages 
go  far  to  offset  the  decrease  in  overhead  costs  which  results  from  greater 
volume  of  business,  so  that  the  early  stages  of  recovery  do  not  bring 
large  profits  to  manufacturers,  except  where  monopoly  conditions  are 
present. 

After  a  time,  however,  in  one  industry  after  another  the  expansion 
of  demand  reaches  the  stage  where  manufacturers  decide  that  it  will 
pay  to  raise  prices  even  at  the  risk  of  losing  some  orders,  and  when 
this  process  starts  it  is  likely  to  gain  momentum.  An  increase  of 
prices  at  one  point  means  an  increase  of  costs  at  another,  and  coming 
in  conjunction  with  an  increase  in  orders  and  inquiries,  it  encourages 
price  increases  where  it  does  not  make  them  imperative. 

At  first,  higher  prices  check  demand,  for  buyers,  both  middlemen 
and  consumers,  are  thinking  in  terms  of  a  falling  or  stationary  price 
level,  and  they  resent  and  resist  advances.  But  when  increases 
become  numerous  enough  to  create  an  expectation  of  further 
increases,  they  begin  stimulating,  instead  of  retarding,  purchases. 
Present  purchases  and  contracts  for  future  purchases  are  made  in 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE  67 

anticipation  of  further  advances,  and  speculators,  middlemen,  and 
consumers  begin  to  accumulate  larger  stocks. 

Prosperity  tends  to  develop  into  excessive  activity ,  which  in  turn 
causes  a  reaction .  No  sharp  line  can  be  drawn  between  the  periods 
known  as  those  of  recovery  and  of  prosperity,  but  it  is  possible  to  draw 
a  fairly  clear  distinction  between  a  wholesome  type  of  prosperity  and 
the  overexpansion  which  often  appears  as  a  result  of  prosperity  and 
brings  it  to  a  close.  For  prosperity  never  passes  into  crisis  without  an 
intermediate  period  of  false  good  times  when  the  industrial  machine, 
though  apparently  running  at  high  speed,  is  really  failing  to  maintain 
its  efficiency  as  an  organization  for  the  satisfaction  of  human  needs, 
and  is  sowing  seeds  of  disaster  for  those  who  are  directing  its  course. 

If  there  were  some  way  by  which  the  progress  of  the  “boom” 
could  be  checked  at  the  point  where  production  reaches  the  largest 
volume  that  existing  resources  make  practicable,  the  real  welfare  of 
the  nation  would  be  greatly  enhanced.  When  all  the  available  labor 
is  employed,  when  our  capital  resources  have  been  adjusted  to  keep 
that  labor  force  employed,  and  when  the  production  of  luxuries  has 
expanded  to  provide  for  a  standard  of  living  corresponding  to  the 
enlarged  income  of  society,  the  real  improvement  has  reached  its 
limit.  No  further  expansion  can  put  more  buying  power  into  one 
person’s  pocket  except  by  taking  out  of  another’s. 

But  unfortunately  there  is  no  force  operating  to  check  the  boom 
at  this  time,  and  there  are  forces  operating  to  drive  it  further.  Of 
these,  the  most  important  is  the  anticipation  of  a  further  rise  in  prices. 
The  higher  prices  go,  and  the  longer  the  time  during  which  they  have 
been  advancing,  the  greater  becomes  the  number  of  people  who  feel 
sure  that  the  next  change  will  be  another  advance,  and  this  conviction 
gives  rise  to  an  epoch  of  speculative  buying.  The  housewife  buys  a 
dozen  cans  of  food  where  ordinarily  she  would  buy  three,  the  retailer 
loads  his  shelves,  and  the  manufacturer  lays  in  an  extra  stock  of  raw 
materials.  Speculators  withdraw  stocks  of  goods  from  the  market. 

The  effect  of  these  withdrawals  of  goods  from  consumption  is  to 
create  temporarily  the  same  situation  which  would  appear  permanently 
if  a  large  part  of  our  current  production  of  wealth  were  withdrawn 
and  sunk  in  the  sea.  The  consumable  product  shrinks  relatively  to 
the  amount  of  social  energy  expended  in  a  production,  and  hence 
the  cost  of  living  outruns  the  advance  in  individual  incomes.  It 
must  do  so.  Individuals  may  succeed  in  obtaining  such  rapid 
advances  of  wages  or  profits  as  will  offset  for  them  the  advance  in 


68 


RISK  AND  RISK-BEARING 


living  costs,  but  the  group,  as  a  whole,  cannot  do  so  if  a  large  part  of 
its  current  product  is  being  withdrawn  from  use  in  anticipation  of 
an  increase  in  its  price. 

At  the  same  time,  the  current  product  itself  is  being  reduced  by 
the  operation  of  forces  inherent  in  the  nature  of  prosperity.  The 
pressure  of  competition  brings  with  it  an  accumulation  of  wastes. 
Equipment  is  kept  in  operation  which  might  better,  as  a  long-run 
policy,  be  sent  to  the  repair-shop  or  the  junk  heap.  Managers 
harassed  by  customers  demanding  prompt  deliveries  neglect  details  of 
economy.  Imperfect  goods  are  shipped  to  customers  on  the  theory 
that  time  is  more  important  than  quality,  and  customers  accept 
inferior  goods  rather  than  risk  getting  none  at  all.  The  efficiency  of 
labor  declines,  and  labor  absenteeism  increases.  Strikes  multiply, 
and  insubordination  manifests  itself.  At  the  same  time,  interest 
rates  rise,  and  if  the  expansion  of  business  is  very  marked,  transporta¬ 
tion  facilities  prove  inadequate. 

All  these  difficulties  accentuate  the  difficulty  of  making  individual 
incomes  and  expenditures  balance.  The  boom  is  no  longer  adding  to 
the  real  welfare  of  the  nation.  It  is  subtracting  from  the  total  pro¬ 
duced  at  the  same  time  that  it  is  inducing  individuals  to  store  up  part 
of  the  product  for  future  consumption,  usually  for  consumption  at  a 
time  when  it  will  be  less  acutely  needed  than  it  is  at  the  time  it  goes 
into  hiding. 

The  transition  from  prosperity  to  depression  is  the  shortest  stage  of 
the  cycle,  but  has  attracted  more  attention  than  has  any  other  stage, 
on  account  of  the  spectacular  character  which  it  often  displays  and 
the  disastrous  consequences  which  it  entails.  According  to  the 
severity  of  its  symptoms,  this  stage  is  variously  denominated  a  period 
of  retrogression,  of  liquidation,  of  crisis,  or  of  panic.  The  outstanding 
characteristics  of  the  period  are  pessimism,  conservatism,  and  caution. 
Instead  of  reaching  out  for  larger  worlds  to  conquer,  the  captains  of 
industry  seek  to  guard  their  frontiers. 

In  brief,  liquidation  consists  of  two  processes:  first,  the  liquida¬ 
tion  of  stocks  of  goods  and  securities,  by  selling  them  or  using  them 
up  without  buying  or  producing  an  equal  quantity  to  replace  them; 
and  second,  the  liquidation  of  credit,  by  collecting  notes  and  accounts 
without  extending  credits  in  equal  amount  to  replace  them.  If  the 
process  were  carried  through  to  completion,  all  business  men  at  the 
end  of  the  period  would  have  their  net  working  capital  in  cash,  with 
no  inventories  or  accounts;  banks  would  have  no  loans  outstanding; 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE  69 

and  all  stocks  and  bonds  would  be  in  the  hands  of  permanent 
investors. 

Of  course,  in  practice  nothing  remotely  approaching  this  actually 
happens.  Individuals  liquidate  their  holdings  of  raw  materials, 
finished  goods,  and  securities,  but  only  by  transferring  them  to  others 
who  are  under  less  pressure.  The  total  of  bank  loans  is  but  slightly 
reduced  in  the  most  drastic  period  of  liquidation.  What  occurs  is  a 
season  of  testing  by  which  the  stronger  firms  gain  at  the  expense  of  the 
weaker.  One  bank  may  turn  its  loans  into  cash,  but  only  on  condi¬ 
tion  that  other  banks  stand  ready  to  rediscount  them  or  to  loan  the 
funds  to  those  who  are  pressed  for  payment;  one  speculator  may 
liquidate  his  holdings  of  stocks  or  of  goods  on  condition  that  others 
can  secure  the  funds  to  take  the  load  off  his  shoulders. 

In  a  period  of  expansion,  such  as  was  described  above,  the  culmina¬ 
tion  of  prosperity  and  the  beginning  of  a  downward  trend  may  take  the 
form  of  pressure  for  liquidation  in  either  the  commodity,  the  security, 
or  the  short-time  credit  market.  In  1907,  for  instance,  it  was  pressure 
for  credit  beyond  the  capacity  of  banks  to  supply  it  which  precipitated 
the  effort  to  liquidate  by  dumping  goods  on  the  market  and  slackening 
production;  in  1920  it  was  the  overexpanded  stocks  of  certain  com¬ 
modities,  notably  silk  and  sugar,  which  led  to  the  demand  for  liquida¬ 
tion  of  loans;  in  1903  the  center  of  strain  was  in  the  security  market. 
In  either  case,  the  liquidation  movement  when  once  started  gains 
momentum  of  itself. 

In  the  commodity  markets,  a  relatively  small  amount  of  forced 
selling,  which  may  be  brought  about  either  by  apprehension  concern¬ 
ing  the  market  for  the  goods  so  sold  or  on  account  of  tension  at  some 
other  point,  exerts  a  depressing  influence  on  prices  and  creates  an 
apprehension  of  further  selling.  Holders  who  are  under  no  real 
pressure  market  their  goods  as  soon  as  they  become  apprehensive, 
make  advance  sales  to  profit  by  the  prospective  decline,  or  curtail 
purchases  and  use  up  the  stocks  they  have  on  hand.  This  depresses 
prices  further,  and  the  fall  of  prices  creates  financial  embarrassment, 
for  goods  are  a  basis  of  credit,  and  on  a  falling  market  curtailment 
of  credit  is  imperative.  The  financial  embarrassments  necessitate 
further  distressed  selling,  and  so  the  downward  spiral  proceeds. 

To  avoid  complete  demoralization,  there  must  be  provided  some 
organization  to  check  the  violence  of  liquidation  and  maintain  prices. 
This  organization  can  be  most  effectively  furnished  by  the  banks, 
particularly  if,  as  in  this  country  in  1920  and  in  England  at  earlier 


70 


RISK  AND  RISK-BEARING 


times  of  crisis,  they  are  well  enough  organized  to  resist  the  temptation 
to  try  to  force  liquidation  ahead  of  one  another.  Credit  extensions 
are  arranged,  and  funds  are  provided  to  withhold  sufficient  goods  from 
the  market  to  hold  prices  up  as  far  as  seems  feasible.  If  the  banks  are 
unable  to  do  this,  if  each  strives  to  protect  itself  by  selling  its  securities, 
withdrawing  its  balances  from  other  institutions,  and  pressing  its 
debtors  for  settlement,  crisis  passes  into  panic.  But  if  organization 
is  successful  in  averting  the  peril,  the  period  is  characterized  by 
“ orderly  liquidation.”  Prices  of  raw  materials  decline;  production  is 
curtailed  in  order  to  apply  receipts  to  payment  of  pressing  obligations 
and  also  to  avoid  losses  from  further  price  declines;  the  weakest 
firms  pass  into  bankruptcy,  and  the  next  weakest  submit  to  “voluntary 
reorganization”  which  transfers  control  to  their  principal  creditors; 
but  there  is  no  panic  and  no  sudden  collapse  of  the  market  for  basic 
commodities. 

A  similar  process  of  liquidation  takes  place  in  the  stock  market, 
where  indeed  it  usually  begins  some  months  earlier  than  in  the  com¬ 
modity  market.  Even  more  than  is  the  case  in  the  market  for  raw 
materials  and  manufactured  products,  the  stock  market  is  financed  on 
borrowed  funds.  Hence  it  is  subject  to  exactly  the  same  sort  of 
pressure  which  we  have  described  in  connection  with  the  commodity 
markets.  A  decline  in  prices,  however  caused,  precipitates  distressed 
selling  by  borrowers  to  protect  their  loans;  this  depresses  prices 
further;  buying  is  deterred  and  speculative  selling  encouraged  by  the 
decline,  and  this  still  further  weakens  the  security  pledged  for  loans. 
The  process  is  more  rapid  than  in  other  markets,  because  the  propor¬ 
tion  of  credit  is  higher  and  because  lenders  on  stock-market  collateral 
do  not  feel,  as  a  rule,  the  same  obligation  to  try  to  protect  their 
debtors  as  do  trade  creditors  and  banks  loaning  to  business  men  on 
the  security  of  inventories  and  accounts.  Here  also,  as  in  the  com¬ 
modity  market,  the  situation  has  been  saved  again  and  again  by  the 
intervention  of  the  stronger  banks.  By  buying  in  large  blocks,  by 
extending  credit  to  finance  buying  by  others,  and  by  mutual  agreement 
to  refrain  from  forcing  liquidation  by  holders  of  large  blocks  of  stock, 
panic  is  prevented. 

Such  are  the  major  features  of  the  liquidation  process;  other 
features  of  the  period  of  retrogression  need  scant  notice  only.  Rail¬ 
road  gross  earnings  remain  large  at  first,  because  commitments  already 
entered  into  are  carried  out,  and  because  the  liquidation  process  itself 
gives  rise  to  a  considerable  volume  of  trade.  Later  they  decline 


7i 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 

4 

violently  and  persistently.  Total  bank  transactions  decrease;  bus¬ 
iness  failures  increase  to  from  three  to  six  times  their  former  number, 
and  dividend  payments  are  curtailed  in  many  instances.  Strikes 
continue  numerous;  wages  decline  slowly;  unemployment  increases; 
and  the  cost  of  living  declines  slightly. 

The  liquidation  period  in  the  nature  of  the  case  cannot  continue 
long.  When  it  has  run  its  course,  however,  production  does  not  at 
once  resume  its  previous  trend.  Partly  on  account  of  the  existence 
of  excess  stocks  accumulated  during  the  period  of  rising  prices;  partly 
on  account  of  the  loss  of  general  confidence  in  the  solvency  of  debtors; 
partly  on  account  of  the  fear  of  further  declines  in  prices;  partly 
because  of  a  curtailment  of  consumer  demand  on  account  of  unemploy¬ 
ment  and  business  losses,  a  period  of  dulness  is  nearly  sure  to  follow. 
This  is  the  stage  with  which  our  description  began,  and  with  this  stage 
it  may  close.  We  must  now  turn  our  attention  to  the  underlying 
causes  of  the  phenomenon,  and  particularly  to  the  way  in  which  it 
illustrates  the  disturbing  influence  of  uncertainty  in  a  society  organized 
on  the  assumption  that  individual  business  managers  may  be  expected 
to  find  and  follow  the  lines  of  policy  which  in  the  long  run  are  most 
profitable  to  themselves  and  to  the  society  of  which  they  are  a  part. 

It  is  not  our  purpose  to  review  the  numerous  theories  which  have 
been  advanced  to  account  for  the  rhythm  of  business,  theories  ranging 
from  the  dominance  of  the  profit  incentive  to  the  form  of  the  banking 
system,  from  the  fluctuation  of  the  rainfall  to  the  exploitation  of  labor.1 
Superficially  there  appears  to  be  a  wide  disagreement  among  students 
of  economic  theory  as  to  the  basic  causes  of  the  phenomena  of  the 
cycle,  but  most  of  the  differences  resolve  themselves  into  differences 
of  emphasis  upon  factors  which  are  in  no  way  incompatible  with  one 
another.  Fundamentally,  all  the  theories  which  seem  worthy  of 
extended  consideration  are  variations  of  two  points  of  view.2  One 
group  emphasizes  the  tendency  for  the  supply  of  certain  types  of 
goods  to  get  out  of  adjustment  with  the  demand  for  them.  The 
realization  of  an  undersupply,  for  instance,  causes  a  burst  of  produc¬ 
tion  which  continues  till  an  excess  of  supply  becomes  evident,  and 
this  situation  in  turn  causes  a  slackening  of  activity  which  continues 

1  Leading  theories  are  summarized  in  Mitchell,  Business  Cycles ,  pp.  3-19,  and 
in  Hansen,  Cycles  of  Prosperity  and  Depression  in  the  United  States ,  Great  Britain 
and  Germany ,  pp.  81-96. 

2  In  this  classification  the  author  has  followed  in  part  the  analysis  in  Hansen, 
op.  cit. 


72 


RISK  AND  RISK-BEARING 


till  the  surplus  is  changed  into  a  deficit.  The  other  group  finds  the 
basic  cause  of  the  cycle  in  the  financial  structure  of  society,  including 
under  that  term:  money,  credit,  prices,  and  the  profit  motive.1 

In  the  judgment  of  the  writer,  the  ultimate  causes  of  the  cyclical 
movement  of  business  are  found  in  the  factors  discussed  by  the  writers 
of  the  first  group.  The  arguments  they  have  presented  however  have 
not  been  thoroughly  convincing  because  each  writer  has  discussed  the 
operation  of  the  same  tendency  in  the  case  of  a  different  group  of 
phenomena,  leaving  the  impression  that  in  the  behavior  of  that  partic¬ 
ular  group  is  to  be  found  the  entire  explanation  of  the  cycle  instead 
of  merely  an  illustration  of  the  way  in  which  a  general  tendency  works 
in  a  wider  field. 

The  common  element  which  runs  through  all  the  theories  of  this 
group  is  the  emphasis  on  the  element  of  uncertainty ,  chiefly  uncertainty 
on  the  part  of  producers  and  middlemen  concerning  the  conditions 
that  will  prevail  in  the  market  when  they  are  ready  to  dispose  of  their 
goods. 

This  uncertainty  characterizes  all  modern  industry,  in  contrast 
to  earlier  forms  of  economic  organization,  for  two  principal  reasons, 
namely,  the  length  of  time  involved  in  the  capitalistic  process,  and  the 
durability  of  most  finished  goods,  which  permits  alternate  accumula¬ 
tion  and  liquidation  of  stocks  and  thereby  increases  the  difficulty  of 
predicting  the  demand  at  any  given  time.  It  was  noted  in  chapter  i 
that  the  uncertainty  arising  from  the  length  of  time  involved  in  pro¬ 
duction  and  from  the  dependence  of  producers  on  markets  causes 
irregularity  and  consequent  risk;  the  way  in  which  it  results  in  a 
rhythm  may  be  explained  as  follows: 

In  any  specialized  economic  organization,  there  must  be  some  way 
of  directing  the  specialists  in  order  that  each  commodity  and  each 
service  may  be  produced  in  the  proper  proportion  to  the  others, 
proper,  that  is,  in  the  sense  that  social  energy  is  devoted  to  the  pro¬ 
duction  of  any  commodity  only  up  to  the  point  where  additional 
units  of  it  are  less  useful  (by  some  scheme  of  measurement),  at  least 
are  less  desired  by  those  whose  desires  are  most  effective,  than  addi¬ 
tional  units  of  some  other  product  to  which  the  same  productive 
energy  might  be  applied  instead.  In  our  own  organization,  the 
principal  devices  for  securing  a  balanced  output  are  prices  and  advance 

1  Typical  of  the  first  group  are  the  theories  of  Hull,  Robertson,  J.  M.  Clark 
Warren,  and  England.  The  second  point  of  view  is  represented  by  Mitchell, 
Veblen,  Fisher,  and  Hansen. 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 


73 


orders.  A  falling  off  of  orders  or  a  lowering  of  market  quotations 
gives  warning  to  the  manager  that  the  rate  of  production  should  be 
slackened,  and  vice  versa,  an  increase  of  orders  or  a  rise  in  prices  is  a 
call  from  society  for  an  increase  of  output.  The  price  index  is  avail¬ 
able  to  producers  in  nearly  all  lines,  while  advance  orders  are  avail¬ 
able  to  relatively  few. 

While  this  system  works  fairly  well  in  most  respects  it  has  one 
serious  defect.  Prices  and  orders  give  information  concerning  the 
prospective  state  of  demand  compared  with  the  known  facts  of  present 
and  future  supply,  but  they  give  no  clue  to  the  changes  in  supply 
which  they  are  themselves  likely  to  cause.  What  a  business  man 
needs  to  know  in  order  to  plan  production  scientifically  is  not  merely 
how  many  units  of  his  product  would  be  bought  at  a  given  price,  but 
also  how  many  other  producers  are  reaching  the  same  conclusion  that 
he  is  reaching,  from  the  same  facts,  and  are  making  plans  similar 
to  his  own.  If  the  element  of  time  in  production  could  be  eliminated, 
the  price  system  would  effect  a  smooth  adjustment  of  supply  to  human 
need,  so  far  as  need  can  be  expressed  through  offers  of  purchasing 
power,  but  time  brings  an  ineradicable  element  of  risk.  For  each 
producer  needs  to  know  precisely  what  it  is  impossible  for  all  to  know, 
namely,  how  many  other  producers  are  about  to  take  advantage  of 
the  same  demand  that  he  individually  is  trying  to  take  advantage  of. 
If  A’s  plans  depend  on  B’s  plans  and  B’s  plans  depend  on  A’s  plans, 
there  is  no  escape  from  uncertainty  except  through  an  agreement  of 
the  rivals,  or  through  the  intervention  of  an  outside  control — in  either 
case,  monopoly. 

One  result  of  this  situation  is  a  tendency  to  alternations  of  over- 
and  underproduction.  Let  us  assume  that  at  a  given  time  there  is 
evidence  of  demand  in  a  given  line  sufficient  to  justify  an  increase  in 
the  rate  of  production.  The  first  managers  who  adapt  their  plans  to 
this  situation  are  probably  rewarded  by  increased  profits.  Under 
competition,  however,  the  tendency  is  for  an  increasing  number  of 
persons  to  try  to  take  advantage  of  the  situation,  each  more  or  less 
in  ignorance  of  the  other’s  plans,  and  no  force  intervenes  to  check  the 
continued  increase  of  production  till  it  reflects  itself  in  declining  orders 
and  falling  prices.  By  that  time,  however,  investments  have  been 
made,  contracts  let,  and  operations  started  which  will  result  in  fur¬ 
ther  augmentation  of  the  supply.  Time  is  required  to  check  this 
increase  in  the  volume  of  production,  and  during  this  time  production 
outruns  consumption  unless  consumption  is  stimulated  by  unprofitably 


7t 


RISK  AND  RISK-BEARING 


low  prices.  Moreover,  just  as  was  the  case  on  the  upswing,  the  indica¬ 
tions  that  production  is  being  overdone  result  in  curtailment  of  opera¬ 
tions  by  independent  producers  in  ignorance  of  each  other’s  intentions, 
and  this  tendency  continues  till  output  is  decreased  to  a  rate  below 
that  which  is  economically  justified. 

A  second  cause  of  the  cycle,  very  similar  to  the  first  but  quite 
independent  of  it,  is  the  effect  of  uncertainty  on  the  decisions  of 
speculative  buyers  with  regard  to  the  accumulation  and  decrease  of 
stocks.  Throughout  the  industrial  order,  a  large  part  of  the  transfer¬ 
able  wealth,  including  raw  materials,  half-finished  products,  and  goods 
ready  for  consumption,  is  in  the  hands  of  individuals  who  can,  to  a 
greater  or  less  extent,  adjust  the  size  of  their  holdings  to  changing 
conditions,  and  who  do  as  a  matter  of  fact  adjust  them  chiefly  in 
accordance  with  their  judgment  of  the  probable  course  of  prices.  The 
most  conspicuous  illustration  is  the  case  of  the  simon-pure  speculator, 
who  stands  ready  to  buy  anything  at  any  price  if  he  thinks  it  will  go 
higher,  and  to  throw  everything  on  the  market  if  he  believes  the  price 
is  destined  to  reach  lower  levels.  But  it  is  not  merely  the  speculator 
who  behaves  in  this  fashion.  The  manufacturer  adjusts  his  purchases 
of  raw  materials  and  the  extent  to  which  he  produces  for  stock  to  his 
judgment  of  the  trend  of  prices;  the  middleman  enlarges  his  holdings 
when  he  believes  the  next  price  change  will  be  upward,  and  even  the 
housewife  buys  fifty  pounds  of  sugar  instead  of  ten,  if  she  believes 
that  the  price  is  a  bargain,  a  bargain,  that  is,  compared  with  the 
price  that  is  likely  to  be  charged  her  for  the  next  order. 

This  would  be  of  no  consequence,  so  far  as  the  cyclical  tendency 
is  concerned,  if  all  these  judgments  of  the  trend  of  price  were  formed 
independently,  for  some  would  overbuy  when  others  were  underbuying. 
The  net  result  would  be  a  fairly  steady  rate  of  buying  if  the  number 
of  buyers  was  large,  or  an  unpredictable  irregularity  if  the  number  was 
small.  But  the  judgments  are  not  formed  independently.  They  are 
all  formed,  in  large  part,  on  the  basis  of  the  same  evidence,  and  of  that 
evidence  the  most  influential  part  is  the  trend  of  prices  in  the  recent 
past.  Whatever  prices  have  been  doing  is  accepted  by  a  great  many 
as  the  most  likely  thing  for  them  to  continue  to  do,  so  that  the  higher 
they  go  the  more  the  tendency  to  speculative  buying,  and  the  lower 
they  go  the  more  the  tendency  to  use  up  stocks  and  buy  from  hand 
to  mouth.1 

1  Cf.  Selden,  “Trade  Cycles  and  the  Instinct  of  Anticipation,”  Quarterly 
Journal  of  Economics ,  XVI,  293-310. 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 


75 


The  effect  of  this  tendency  to  mass  movements  of  buying  and 
selling  is  greatly  to  accentuate  the  effect  of  the  producers’  uncertainty 
concerning  one  another’s  plans,  to  which  reference  was  made  in  an 
earlier  section  of  this  chapter.  For  an  increase  in  middlemen’s  stocks 
gives  the  producers  twice  a  false  index  of  the  amount  of  production 
which  is  economically  justifiable.  When  the  increase  in  buying  takes 
place  it  swells  the  volume  of  orders  and  creates  a  false  appearance  of 
expansion  in  the  market,  and  whenever  the  excess  stock  is  utilized  it 
again  gives  a  false  indication,  this  time  of  contraction  in  the  market. 

The  two  tendencies,  it  will  be  noted,  are  of  fundamentally  similar 
character.  Producers  cannot  know  the  future  conditions  of  supply 
accurately  if  they  operate  in  ignorance  of  each  other’s  actions;  hence 
the  tendency  is  for  all  to  act  on  much  the  same  information  and  for 
their  action  to  overshoot  its  intended  effect  alternately  in  opposite 
directions.  Middlemen,  speculators,  consumers,  likewise  operate  to 
a  large  extent  in  ignorance  of  one  another’s  intentions  and  are  likewise 
apt  to  act  simultaneously  on  the  same  information,  giving  rise  to 
alternations  of  abnormally  large  and  abnormally  small  demand  and 
increasing  the  extent  of  the  uncertainty  in  the  minds  of  producers. 

In  the  following  selections,  two  writers  give  illustrations  of  the 
working  of  the  tendency  to  rhythm  in  widely  different  fields  of 
production. 

THE  CYCLE  IN  PRODUCTION  OF  BASIC  CAPITAL  GOODS 

Let  us  suppose  that  for  any  reason  the  exchange  value  of  the  products 
of  any  trade  has  risen.  There  will  then  be  an  inducement  to  increased 
investment  in  that  trade.  But  the  new  instruments  ordered  will  not  be 
immediately  ready  for  use:  meanwhile  the  high  level  of  price  will  continue, 
and  since  each  producer  (in  a  competitive  regime)  is  ignorant  of  the  prepara¬ 
tions  which  are  being  made  by  his  rivals  to  meet  the  high  level  of  prices, 
the  total  amount  of  new  instruments  prepared  will  be  so  great  that  the 

price  of  the  product  eventually  falls  below  its  old  level . The  first 

drop  in  prices  will  occur  as  soon  as  the  first  batch  of  new  instruments  is 
brought  into  use:  the  longer  therefore  this  period  of  gestation,  the  longer 
will  the  period  of  high  prices  continue,  the  greater  will  be  the  over¬ 
investment,  and  the  more  severe  the  subsequent  depression. 

For  instance,  the  price  of  coal  tends  to  reach  both  its  maxima  and 
minima  later  than  that  of  pig-iron.  While  there  are  other  causes  for  this, 
part  of  the  explanation  seems  to  lie  in  the  longer  period  of  gestation  necessary 
in  the  coal  trade.  According  to  Mr.  Hull  it  takes  “practically  a  year”  in 
America  to  build  a  new  blast  furnace.  From  an  English  ironmaster  I 
gather  the  impression  that  in  this  country  some  fifteen  months  would  be 


76 


RISK  AND  RISK-BEARING 


required.  But  a  coal  mine  which  is  begun  to  be  sunk  now  will  not  be  in 
working  order  for  several  years.1 

THE  CYCLE  IN  AGRICULTURAL  PRODUCTION 

Man  is  so  constituted  that  he  is  too  likely  to  think  that  present  condi¬ 
tions  are  to  continue.  If  we  have  a  wet  year  or  two,  we  think  that  it  will 
always  be  wet;  if  good  prices,  these  are  to  remain  forever.  In  the  case  of 
prices,  it  is  the  very  feeling  of  certainty  that  present  conditions  are  to 
continue  that  makes  it  impossible  for  them  to  do  so.  One  of  the  most 
important  gifts  for  man  to  cultivate  is  his  ability  to  forecast  the  future. 
This  ability  is  one  of  the  most  valuable  business  assets. 

The  usual  guide  that  is  followed  in  determining  what  crops  and  animals 
to  produce  is  the  profits  of  the  last  year  or  two,  but  since  prices  may  be 
temporarily  high  or  low,  longer  periods  should  be  considered.  Many 
factors  are  involved.  The  yields  in  the  community  may  be  good  in  a  year 
of  poor  crops,  or  the  community  may  have  poor  crops  in  a  year  of  general 
overproduction  and  low  prices.  Add  to  these  uncertainties  the  fact  that 
the  weather  has  nearly  as  much  to  do  with  the  total  crop  as  the  acreage, 
and  it  is  no  wonder  that  the  farmer  finds  it  difficult  to  tell  what  acreage  to 
plant.  With  the  annual  crops,  the  acreage  is  kept  fairly  close  to  the  coun¬ 
try’s  needs.  The  longer  the  time  required  to  grow  a  product,  the  worse 
the  periods  of  over-  and  underproduction  become.  A  shortage  of  an  annual 
crop  may  be  made  up  in  a  year,  but  it  takes  ten  to  twenty  years  to  adjust 
the  area  of  apples  and  fifty  to  a  hundred  years  to  grow  a  lumber  crop  to 
supply  a  shortage  in  lumber. 

Apples  in  the  Northeastern  States  are  a  good  crop  with  which  to  illus¬ 
trate  this  point.  If  the  supply  of  apples  is  short,  prices  will  be  high.  If 
this  condition  continues  for  a  few  years,  planting  will  be  encouraged,  but 
the  trees  planted  will  have  no  effect  on  the  next  year’s  crop.  Prices  may  go 
still  higher  and  so  stimulate  more  planting.  This  condition  may  continue 
for  twenty  years,  after  which  comes  the  deluge  of  apples,  with  more  trees 
coming  on  every  year.  This  is  what  happened  during  the  past  generation. 
Apples  paid  well  from  1854  to  1864.  From  1864  to  1874  prices  were  very 
high.  They  continued  fairly  good  till  1878.  They  then  dropped  and 
continued  to  drop  till  1896,  when  thousands  of  bushels  were  not  picked. 
Since  1896,  prices  have  been  rising,  and  for  the  last  few  years  they  are  again 
so  high  that  people  are  becoming  wild  about  them. 

Nearly  all  the  bearing  apple  orchards  in  New  York  were  planted  between 
1855  and  1878;  planting  then  practically  stopped.  It  has  been  much  over¬ 
done.  In  the  early  nineties  some  orchards  were  cut  down. 

In  one  township  in  Monroe  County,  New  York,  which  is  in  the  center 
of  the  apple  belt,  57  per  cent  of  the  apple  trees  were  planted  from  1859  to 

1  D.  II.  Robertson,  A  Study  of  Industrial  Production ,  pp.  13-14. 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 


77 


1878;  only  11  per  cent  were  planted  from  1879  to  1903;  while  21  per  cent 
were  planted  from  1904  to  1908 . 

From  the  figures  thus  far  available,  it  appears  that  the  periods  of  over- 
and  underproduction  of  apples  last  about  twenty  to  twenty-five  years,  as 
it  takes  this  time  to  get  enough  trees  raised  to  bearing  age  to  cause  overpro¬ 
duction,  and  about  another  equal  period  of  little  planting  before  prices  rise 
high  enough  to  stimulate  another  planting  wave.  It  would  appear  to 
be  the  part  of  wisdom  for  a  farmer  to  start  planting  or  buying  orchards 
about  the  middle  of  the  low-price  period  when  everyone  is  discouraged, 
and  to  stop  planting  at  the  time  when  prices  are  so  high  that  everyone  is 
planting.  Some  farmers  do  follow  this  practice.  The  farmer  who  planted 
in  the  eighties  has  already  been  rewarded . 

Hogs  usually  rise  in  price  for  two  to  three  years  and  then  drop  for  two 
to  three  years.  A  very  abnormal  corn  crop  shifts  the  hog  curve.  Since 
1866  the  curve  has  been  very  regular  until  1901,  when  the  very  short  corn 
crop  checked  hog  production,  so  that  the  drop  in  hog  prices  did  not  come 
until  two  years  later.  It  takes  about  two  to  three  years  of  low  prices  to 
check  hog  production  and  get  rid  of  the  extra  pigs  that  are  coming  on,  and 
about  two  to  three  years  to  get  production  started  and  the  pigs  raised  to 
marketable  age  so  as  to  again  cause  overproduction.  If  a  farmer  in  the 
corn-belt  changes  his  production  on  account  of  prices,  it  would  appear  to 
be  good  policy  to  raise  a  considerable  number  of  pigs  in  the  second  or  third 
year  of  low  prices,  and  to  be  cautious  about  the  number  raised  in  the  second 
and  third  years  of  high  prices.  When  the  majority  are  disgusted  with  the 
business  is  a  good  time  to  buy;  when  the  majority  are  declaring  that  prices 
will  never  again  be  low  is  a  good  time  to  sell . 

Prices  of  horses  show  the  same  cycle,  but  it  takes  a  long  time  to  grow 
enough  colts  to  overstock  the  market,  apparently  eight  to  ten  years.  Those 
who  were  first  to  start  raising  colts  after  the  ruinous  prices  of  1896  made  a 
good  profit.  When  the  price  of  horses  drops  very  low,  it  would  appear  to 
be  the  part  of  wisdom  to  sell  all  the  old  horses  and  buy  young  ones  that  will 
still  be  living  when  prices  rise.1 

It  will  be  noted  that  the  fundamental  reasons  given  by  Warren 
for  the  fluctuation  of  the  price  of  farm  products  is  the  same  as  that 
given  by  Robertson  for  the  fluctuation  of  volume  of  the  production  of 
coal.  In  each  case,  the  essential  thing  is  the  point  to  which  reference 
was  made  above — the  impossibility  of  eliminating  the  uncertainty 
which  arises  under  conditions  of  competition,  from  one  competitor’s 
ignorance  of  what  other  competitors  are  going  to  do.  As  Warren 
notes,  “It  would  appear  to  be  good  policy  to  raise  a  considerable 
number  of  pigs  in  the  second  or  third  year  of  low  prices”  and  “  to  start 

1  G.  F.  Warren,  Farm  Management,  pp.  83-90.  Copyrighted,  The  Macmillan 
Company.  Reprinted  by  permission. 


78 


RISK  AND  RISK-BEARING 


planting  or  buying  orchards  when  everyone  is  discouraged.”  This  is 
very  good  advice  for  the  individual  farmer,  but  it  does  not  solve  the 
social  difficulty,  for  if  everybody  starts  planting  when  everybody  is 
discouraged,  it  is  evident  that  nobody  is  really  discouraged,  and  the 
result  of  a  universally  efficient  attempt  to  concentrate  production  in 
the  second  or  third  year  of  low  prices  would  be  to  insure  a  still  further 
descent  of  prices.  For  the  present  it  does  not  appear  likely  that  such 
advice  will  be  so  universally  accepted  as  to  make  its  acceptance 
disastrous,  but  it  is  easy  to  see  that  the  efficiency  of  such  instruction 
depends  on  its  own  inefficiency.  The  problem  is  very  much  like  that 
of  spreading  the  Christmas  trade.  To  induce  people  to  do  their 
Christmas  shopping  early  is  to  confer  a  mutual  benefit  on  the  shoppers, 
the  clerks,  and  the  retailers,  but  if  a  prophet  should  arise  to  preach 
the  gospel  of  early  shopping  with  such  fervor  that  everybody  tried  to 
do  his  Christmas  shopping  in  the  first  week  of  November,  the  results 
would  be  disastrous.  The  prophet’s  social  value  depends  on  the 
limitations  of  his  own  prophetic  efficiency. 

In  the  case  of  the  agricultural  operations  discussed  by  Warren, 
the  cycle  is  a  special  cycle  in  the  individual  industry.  In  any  line  of 
competitive  production  where  there  is  a  large  time  element  involved 
in  the  adjustment  of  the  rate  of  production,  this  cyclical  tendency 
shows  itself.  With  regard  to  a  large  class  of  commodities,  however, 
the  conditions  of  production  in  one  field  have  a  direct  bearing  on  the 
prosperity  of  producers  in  another  field,  so  that  the  tendency  is  for 
the  ups  and  downs  of  many  of  our  most  important  branches  of  produc¬ 
tion  to  run  together,  giving  rise  to  the  phenomenon  known  as  the  busi¬ 
ness  cycle.  Transportation,  manufacture  of  steel  and  copper,  and  of 
building  materials,  the  production  of  luxuries  for  laborers’  consump¬ 
tion,  the  fuel  industries,  all  are  bound  up  very  closely  with  one  another. 
Financial  institutions,  such  as  banks,  brokerage  houses,  and  insurance 
companies  find  their  prosperity  directly  dependent  upon  the  activity 
of  business  in  other  important  lines.  In  fact,  outside  the  field  of 
agriculture,  a  superficial  examination  of  the  facts  leads  to  the  con¬ 
clusion  that  prosperity  and  depression  are  phenomena  characteristic 
of  the  entire  business  community  rather  than  of  individual  trades. 
And  even  in  agriculture,  some  influence  of  the  business  cycle  is  clearly 
to  be  seen,  though  it  is  often  overshadowed  by  the  influence  of  other 
conditions.  There  are  however  numerous  industries  which  are  almost 
immune  from  the  cyclical  tendency. 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 


79 


The  following  selection  furnishes  a  more  detailed  analysis  of  the 
operation  of  the  tendency  to  rhythm  in  the  errors  made  both  by 
producers  of  basic  goods  and  by  middlemen  in  the  accumulation  and 
liquidation  of  stocks: 

Every  producer  of  things  to  be  sold  to  producers  has  two  demands  to 
meet.  He  must  maintain  the  industrial  equipment  already  in  use  and  the 
stocks  of  materials  and  goods  on  their  way  to  the  final  consumer,  and  he 
must  also  furnish  any  new  equipment  that  is  wanted  for  new  construction, 
enlargements,  or  betterments,  and  any  increase  in  the  stocks  of  materials 
and  unsold  goods.  Both  these  demands  come  ultimately  from  the  consumer, 
but  they  follow  different  laws.  The  demand  for  maintenance  and  replace¬ 
ment  of  existing  capital  varies  wdth  the  amount  of  the  demand  for  finished 
products,  while  the  demand  for  new  construction  or  enlargement  of  stocks 
depends  upon  whether  or  not  the  sales  of  the  finished  product  are  growing. 
Normally,  over  a  long  period  of  years,  there  is  a  certain  demand  for  new 
construction  on  which  producers  can  rely,  and  hence  the  demand  for  new 
construction  is  a  normal  part  of  any  demand  schedule  for  this  kind  of  goods. 
But  it  does  not  come  regularly . 

The  demand  for  a  certain  product,  let  us  say,  begins  to  increase  steadily, 
each  year  seeing  an  increment  equal  to  io  per  cent  of  the  original  demand. 
At  the  end  of  five  years  the  increase  stops  and  the  demand  remains  station¬ 
ary.  If  the  productive  equipment  has  kept  pace  with  the  need,  it  is  now 
enlarged  by  50  per  cent  and  calls  for  50  per  cent  more  expenditure  for 
maintenance  and  replacements.  Meanwhile  there  has  been  an  added  de¬ 
mand  for  new  construction  equal  in  five  years  to  half  the  entire  original  equip¬ 
ment.  If  renewals  are  at  the  rate  of  5  per  cent  a  year,  the  first  effect  of  an 
increase  in  demand  at  the  rate  of  10  per  cent  in  a  year  is  to  treble  the  de¬ 
mand  for  the  means  of  production,  since  a  demand  for  new  construction  has 
arisen  twice  as  large  as  the  previous  demand  for  maintenance. 

What  happens  at  the  end  of  the  five  years  when  the  demand  stops 
growing  ?  By  this  time  the  requirements  for  maintenance  are  50  per  cent 
greater  than  they  were  while  new  construction  has  been  going  on  at  a  rate 
equal  to  twice  the  original  maintenance  account.  The  total  output  has 
grown  to  three  and  one-half  times  its  former  volume.  But  the  demand  for 
new  construction  now  ceases  abruptly.  This  means  that  if  the  producers 
engaged  in  construction  work  had  enough  capacity  to  meet  the  demand 
of  the  fifth  year  the  sixth  year  would  see  them  running  with  four-sevenths 
of  their  capacity  idle. 

Thus  the  law  of  demand  for  intermediate  products  states  that  the 
demand  depends  not  only  on  the  demand  for  the  final  product,  but  on  the 
manner  in  which  that  demand  is  fluctuating.  Making  all  due  allowances 
for  mitigating  factors  in  translating  the  illustration  back  into  real  life,  it  is 


8o 


RISK  AND  RISK-BEARING 


still  difficult  to  see  how  the  building  and  machine-making  industries  can 
possibly  avoid  the  disagreeable  experience  of  outgrowing  themselves  in 
time  of  prosperity.  For  demand  can  never  be  expected  to  grow  at  an 
absolutely  steady  rate,  and  the  slightest  fluctuation  seems  destined  to  put 
the  producer  of  capital  goods  in  a  situation  comparable  to  that  of  a  passenger 
forcibly  carried  by  his  station. 

This  principle  may  be  illustrated  by  a  town  which  grows  rapidly  up  to 
the  size  at  which  its  industrial  advantages  are  fully  utilized  and  beyond 
which  its  normal  production  can  expand  but  slowly.  When  the  point  of 
transition  is  reached  from  rapid  to  slow  expansion,  the  town  may  find 
that  it  has  outgrown  itself  by  the  number  of  people  engaged  in  the  extra 
construction  work  involved  in  the  process  of  growing.  Houses  to  take  them 
in,  stores  to  feed  and  clothe  them,  trucks  to  haul  the  materials  they  work 
with,  offices,  etc.,  all  will  be  demanded,  and  thus  a  boom  may  be  created 
which  is  none  the  less  temporary  for  being  based  on  tangible  economic  needs. 

The  chief  reasons  for  keeping  a  stock  are,  first,  to  give  the  customer  a 
wide  selection  of  goods  which  he  can  actually  inspect  and,  secondly,  to  give 
assurance  of  being  able  to  fill  large  orders  without  delay.  What  is  the 
effect  of  expanding  demand  on  the  amount  of  stock  needed  to  fulfil  these 
functions?  Obviously,  the  larger  the  orders,  the  greater  the  danger  of 
being  sold  out,  unless  the  stock  is  increased  in  a  corresponding  proportion, 
or  something  not  too  far  short  of  it.  The  increase  in  demand  would  not 
seem  to  make  it  necessary  to  keep  any  wider  range  of  goods  in  stock.  But 
if  we  are  thinking,  not  of  what  is  necessary,  but  of  what  is  profitable,  we 
have  a  different  situation.  Some  goods  which  were  just  below  the  line  of 
toleration  will  become  profitable  to  handle  on  the  basis  of  the  increased 
rate  at  which  they  can  be  sold,  and  the  natural  result  is  the  carrying  of  a 
greater  variety  of  goods  as  well  as  the  more  goods  of  each  kind. 

If  the  dealer  is  in  doubt  whether  or  not  to  keep  a  certain  line  in  stock 
at  all,  a  brisk  state  of  demand  will  be  likely  to  decide  him  to  keep  it . 

One  other  fact  which  may  make  merchants  more  willing  to  invest  in 
considerable  stocks  is  that  a  time  of  growing  demand  for  some  one  com¬ 
modity,  or  a  time  of  general  increase  in  activity,  are  both  times  of  rising 
prices  for  the  intermediate  products  called  for  in  the  business  affected. 
This  makes  these  commodities  a  profitable  investment  so  long  as  credit  can 
be  had  on  easy  terms  with  which  to  enlarge  one’s  holdings. 

Taking  all  these  things  into  consideration,  one  is  justified  in  conclud¬ 
ing  that  an  increase  in  demand  naturally  tends  toward  an  increased  invest¬ 
ment  in  dealers’  stocks,  which  is,  if  anything,  more  than  in  proportion  to 
the  increase  in  sales,  unless  limited  by:  (i)  difficulty  in  getting  added  credit 
to  carry  the  extra  “working  capital,”  (2)  an  extremely  sharp  rise  in  supply 
prices,  (3)  the  fear  that  the  prosperity  is  temporary,  or  (4)  the  inability  of 
manufacturers  to  make  deliveries. 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE 


81 


So  far  we  have  considered  only  one  big  division  of  the  process.  If  we 
imagine  the  effect  of  all  this  on  those  industries  which  produce  the  tools 
and  machinery  used  in  the  construction  industry  itself,  we  have  a  further 
possibility  of  multiplying  the  effects  of  a  change  in  demand.  In  fact,  the 
possibilities  multiply  with  every  step  backward,  for  every  industry  which 
produces  the  means  of  production  for  some  other  industry  has  its  own 
demand  for  its  own  tools  and  machinery  to  be  filled.  These  possibilities 
of  intensification  are  soon  mitigated,  however,  by  the  fact  that  as  we  get 
farther  and  farther  back  we  reach  industries  which  produce  machinery  and 
tools  for  a  large  number  of  other  industries  at  once,  so  that  they  register  the 
effect  of  the  average  of  a  great  many  changes  in  a  great  many  particular 
lines  of  production.  Thus  we  finally  reach  the  steel  industry,  which  pro¬ 
duces  the  chief  of  all  the  raw  materials  used  in  making  capital  goods.  This 
industry  is  so  large  that  a  change  in  the  demand  for  any  comparatively 
unimportant  product,  however  much  it  may  be  intensified  in  the  way  we 
have  just  studied,  has  no  appreciable  effect  on  the  great  mass  of  steel  pro¬ 
duction  of  the  country.  Only  the  largest  industries  buy  enough  steel  to 
have  a  decided  effect  on  the  demand  for  this  basic  material.  Railroading, 
which  itself  is  to  a  very  large  extent  engaged  in  the  production  of  inter¬ 
mediate  products,  furnishes  the  steel  industry  with  an  outlet  for  its  products 
which  is  so  large  as  to  be  quite  decisive  and  at  the  same  time  so  fluctuating 
as  to  be  a  constant  barometer  of  prosperity  or  of  depression.  And  the  steel 
industry  itself  is  an  equally  important  barometer,  reporting  in  intensified 
form  all  general  movements  which  originate  with  businesses  closer  to  the 
final  sale  of  the  product. 

In  summary,  the  main  principles  contended  for  are  as  follows: 

1.  The  demand  for  enlarging  the  means  of  production  (including  stocks 
of  finished  goods  on  the  way  to  the  consumer)  varies,  not  with  the  volume 
of  the  demand  for  the  finished  product,  but  rather  with  the  acceleration  of 
that  demand,  allowance  being  made  for  the  fact  that  the  equipment  cannot 
be  adjusted  as  rapidly  as  demand  changes,  and  so  may  be  unusually  scarce 
or  redundant  to  start  with  in  any  given  period.  The  demand  for  equip¬ 
ment  may  decrease  as  a  result  of  this  law  even  though  the  demand  for  the 
finished  product  is  still  growing. 

2.  The  total  demand  for  producers’  goods  tends  to  vary  more  sharply 
than  the  demand  for  finished  products,  the  intensification  being  in  propor¬ 
tion  to  the  average  life  of  the  goods  in  question. 

3.  The  maximum  and  minimum  points  in  the  demand  for  producers’ 
goods  tend  to  precede  the  maximum  and  minimum  points  in  the  demand 
for  the  finished  products,  the  effect  being  that  the  change  may  appear  to 
precede  its  own  cause.1 

1  Adapted  by  permission  from  J.  M.  Clark,  “Business  Acceleration  and  the 
Law  of  Demand,”  Journal  of  Political  Economy,  XXV  (March,  1917),  217-35. 


82 


RISK  AND  RISK-BEARING 


The  principles  explained  in  the  preceding  pages  seem  to  be  the 
basic  causes  of  the  business  cycle;  basic  in  the  sense  that  they  are 
adequate  to  account  for  a  cycle  without  the  presence  of  other  factors, 
such  as  a  particular  monetary,  credit,  or  profit-making  system,  to 
co-operate  with  them.  On  the  other  hand,  given  a  cycle  of  production 
caused  by  the  operation  of  the  factor  of  uncertainty  in  the  way  just 
outlined,  fluctuations  in  the  level  of  profits,  in  the  rates  of  interest, 
and  in  the  stock  of  money  must  inevitably  follow,  and  must  in  turn 
profoundly  modify  the  problem  of  managing  production.  As  was 
indicated  in  the  earlier  portions  of  this  chapter,  credit  operates  to 
exaggerate  the  violence  of  liquidation,  or  to  check  it,  according  as  the 
principal  creditors  are  well  or  ill  organized.  High  prices,  lagging 
wages,  and  lagging  interest  rates  increase  the  level  of  profits  and  stimu¬ 
late  further  increases  in  productive  activity.  But  it  is  easy  to  exag¬ 
gerate  the  influence  of  profit  margins.  Business  men  are  willing  to 
operate  on  a  narrow  margin  of  profit  if  the  margin  is  sure,  or  reasonably 
probable,  and  an  increased  volume  of  orders,  whether  due  to  specula¬ 
tive  accumulation  or  to  pressure  of  actual  consumers’  demand,  even 
when  the  level  of  costs  and  prices  is  such  as  to  make  profits  narrow 
and  uncertain,  operates  to  stimulate  a  quick  expansion  of  output. 
Profit  margins  seem  to  result  from,  rather  than  to  cause,  the  major 
changes  in  business  activity. 

We  may  summarize  the  conclusions  of  this  chapter  as  follows: 
The  cycle  is  not  merely  a  phenomenon  of  finance.  The  conditions  of 
uncertainty  under  which  production  is  carried  on  at  the  present  time 
tend  to  create  a  rhythm  of  over-  and  underproduction  in  the  case  of 
many  important  industries.  The  fluctuation  is  more  violent  in  the 
case  of  producers’  goods,  because  the  cycle  itself  creates  fluctuations 
in  the  demand  for  them  which  accentuate  the  fluctuations  due  to  the 
alternate  over-  and  underestimates  of  probable  supply.  The  character 
of  the  cycle  varies  widely  from  one  industry  to  another.  Its  character 
is  influenced  chiefly  by  the  following  considerations: 

1.  The  length  of  time  required  to  adjust  the  rate  of  production  to 
the  state  of  demand.  When  production  requires  little  antecedent 
preparation  the  cyclical  tendency  is  at  a  minimum. 

2.  The  extent  to  which  production  is  governed  by  factors  outside  the 
control  of  managers. 

3.  The  number  of  independent  producers.  In  general,  the  larger 
the  number  of  competing  producers,  the  greater  the  difficulty  in  getting 


UNCERTAINTY  AND  THE  BUSINESS  CYCLE  83 

information  which  will  prevent  the  maladjustments  which  result  in  a 
cycle. 

4.  The  extent  to  which  it  is  possible  to  store  up  the  product  for  future 
needs .  The  more  readily  the  product  is  accumulated,  the  greater  the 
tendency  to  variation  in  the  demand. 

5.  The  extent  to  which  the  particular  line  of  production  is  independent 
of  other  lines  in  its  activity . 


QUESTIONS 

1.  Describe  the  conditions  prevailing  in  a  typical  period  of  prosperity;  of 
depression. 

2.  Analyze  the  current  business  situation  with  a  view  to  determining  (a) 
what  is  the  present  phase  of  the  cycle;  ( b )  to  what  extent  the  present 
situation  corresponds  to  that  described  as  typical  of  this  stage. 

3.  What  is  meant  by  liquidation  of  credits?  liquidation  of  inventories? 
Are  the  two  processes  sufficiently  similar  to  justify  our  calling  them  by 
the  same  name  ? 

4.  Is  liquidation  of  one  of  these  two  types  (question  3)  likely  to  cause 
liquidation  of  the  other  type  ?  Is  the  process  more  likely  to  proceed  in 
one  direction  than  in  the  other  ? 

5.  In  heating  a  house  by  the  use  of  an  oil  burner  controlled  by  a 
thermostat,  alternations  of  overheating  and  underheating  occur,  which 
are  more  marked  if  a  hot-water  heating  system  is  used  than  with  a  hot-air 
system.  Show  how  this  difference  illustrates  a  tendency  operative  in 
causing  greater  cyclical  fluctuations  in  some  types  of  business  activity 
than  in  others. 

6.  How  do  the  following  factors  determine  the  extent  to  which  a  given  line 
of  business  is  affected  by  the  cyclical  tendency  ?  (a)  the  extent  to  which 
production  is  governed  by  factors  outside  the  control  of  managers;  (b) 
the  extent  to  which  the  particular  line  is  independent  of  other  lines  ? 

7.  Which  class  of  commodities  have  the  more  violent  fluctuations  in  price, 
perishables  or  durable  commodities?  (Consider,  first,  fluctuations  in 
price  connected  with  tbe  business  cycle,  and  second,  fluctuations  due  to 
maladjustments  in  the  industry  itself,  due  to  non-cyclical  causes.) 


CHAPTER  VI 

BUSINESS  FORECASTING 

Broadly  interpreted,  the  term  “business  forecasting”  might 
include  practically  the  whole  range  of  activities  which  aim  at  the 
elimination  of  business  risk  by  the  reduction  of  uncertainty.  As 
was  indicated  in  chapter  iii,  the  range  of  methods  used  in  business 
research  is  so  great,  and  the  problems  are  so  much  a  part  of  the  tech¬ 
nique  of  individual  lines  of  business,  that  it  is  not  practicable  in  a 
general  work  of  this  character  to  examine  them  in  detail.  One  phase 
of  the  development  of  business  research,  however,  touches  so  wide 
a  range  of  enterprises  and  promises  to  be  of  so  great  importance  for 
business  in  general  that  it  may  properly  be  given  fairly  detailed  con¬ 
sideration.  This  is  the  technique  of  forecasting  the  coming  and  going 
of  prosperity  and  depression,  which  is  generally  referred  to  as  “busi¬ 
ness  forecasting”  in  the  narrower  and  more  specific  use  of  the  term. 
The  present  chapter  deals  with  forecasting  in  this  narrower  sense. 

During  the  last  ten  years  there  has  been  a  great  increase  of  interest 
in  the  problem  of  predicting  the  course  of  the  business  cycle,  partly 
because  the  changes  in  business  activity  and  in  the  level  of  prices  have 
been  of  unusual  magnitude  and  suddenness,  and  partly  because  the 
advance  of  economic  science  has  made  it  possible  to  speak  with  more 
confidence  concerning  the  main  outlines  of  a  technique  of  forecasting. 
The  pioneers  in  the  development  of  business  forecasting  were  the  com¬ 
mercial  business  service  agencies,  particularly  the  Babson  Statistical 
Service  and  the  Brookmire  Economic  Service.  Within  the  past  ten 
years,  the  problem  has  been  attacked  vigorously  by  academic  students, 
notably  by  Professor  Wesley  C.  Mitchell  in  his  study  of  Business 
Cycles ,  more  recently  through  detailed  statistical  studies  by  Professor 
Warren  M.  Persons  and  by  the  staff  of  the  Harvard  Economic  Service. 
Commercial  barometers,  moreover,  have  multiplied,  and  financial  and 
business  periodicals  have  come  to  devote  much  space  to  analyses  of 
the  trend  of  business  activity. 

Complete  analysis  of  the  causes  which  are  making  for  change  in  the 
business  situation  would  be  by  far  the  most  satisfactory  method  of  fore¬ 
casting  if  it  were  practicable. — Such  an  analysis,  however,  is  wholly 
impossible.  By  this  is  meant  not  merely  that  a  mathematically  com- 

84 


BUSINESS  FORECASTING 


85 


plete  and  exhaustive  survey  of  all  the  facts  necessary  to  such  an  analy¬ 
sis  is  impossible,  but  that  even  such  an  approximation  as  will  serve 
the  practical  needs  of  business  involves  difficulties  so  great  that  at 
no  time  will  the  conclusions  of  competent  students  arrived  at  inde¬ 
pendently  in  this  way  be  unlikely  to  be  in  substantial  disagreement. 
Such  an  analysis  would  require  a  survey  of  the  extent  of  existing  stocks 
of  goods  held  by  producers,  by  middlemen,  and  by  consumers,  of  the 
rates  at  which  production  and  consumption  were  adding  to,  or  sub¬ 
tracting  from,  these  stocks,  and  of  the  ideas  men  held  as  to  the  desira¬ 
bility  of  increasing  or  decreasing  these  stocks  or  changing  these 
rates  of  consumption  and  production.  It  would  require  also  a  more 
accurate  knowledge  than  anyone  can  hope  to  attain  of  the  future 
course  of  politics  and  of  legislation,  of  the  future  of  the  weather  and 
the  consequent  yield  of  leading  crops,  of  the  elasticity  of  consumers’ 
demand,  of  the  tendency  of  fashions  and  changes  in  tastes,  and  of 
other  factors  so  numerous  and  so  elusive  as  to  defy  accumulation 
and  comparison  of  the  necessary  data. 

A  limited  number  of  items  may  serve  as  an  acceptable  index  of  the 
general  situation. — The  overwhelming  difficulties  in  the  way  of  col¬ 
lecting  the  data  necessary  for  a  complete  analysis  of  the  business 
outlook  at  any  given  time  may  be  overcome  to  a  large  extent  by  using 
the  device  known  to  statisticians  as  sampling.  A  limited  number  of 
items  are  chosen  for  careful  study,  and  the  remaining  evidence  is 
ignored  on  the  theory  that  if  the  items  chosen  for  study  are  really 
representative  and  are  fairly  numerous,  no  serious  error  is  likely  to 
result  from  treating  the  sample  as  though  it  were  the  whole  body  of 
evidence.  This  sample  may  be  selected  in  either  of  two  ways.  The 
attempt  may  be  made  to  pick  out  the  most  important  causes  of  busi¬ 
ness  changes,  such  as  changes  in  crops,  contraction  and  expansion 
of  available  supplies  of  credit,  and  taxation,  keep  close  watch  of  them, 
and  ignore  the  rest.  Or,  the  course  of  past  cycles  may  be  studied  to 
determine  what  statistical  data  have  most  faithfully  reflected  or  pre¬ 
dicted  the  course  of  prosperity  and  depression  in  the  past,  and  a  num¬ 
ber  of  these  items  may  be  followed,  the  assumption  being  that  the 
regularities  which  have  shown  themselves  in  the  past  may  be  expected 
to  continue  in  the  future,  and  that  the  use  of  a  considerable  number  of 
indices  will  protect  the  observer  against  the  danger  of  being  misled 
by  an  accidental  irregularity  in  the  behavior  of  the  items  under  con¬ 
sideration. 

Thus  in  the  attempt  to  develop  a  technique  for  forecasting  the 
course  of  the  business  cycle,  two  methods  have  suggested  themselves, 


86 


RISK  AND  RISK-BEARING 


each  of  which  is  advocated  in  preference  to  the  other  by  a  consider¬ 
able  number  of  students  of  business.  These  methods  may  be  desig¬ 
nated  as  the  method  of  economic  analysis  and  the  method  of  statistical 
comparisons.  The  method  of  economic  analysis  seeks  to  forecast  the 
course  of  the  cycle  in  exactly  the  same  way  that  students  of  the  social 
sciences  generally  try  to  forecast  the  course  of  events  which  are  not 
cyclical  in  character.  This  method  is  simply  to  identify  the  forces 
which  are  making  for  contraction  and  those  which  are  making  for 
expansion  in  business,  weigh  the  one  set  of  factors  against  the  other, 
and  predict  the  course  of  events  in  the  light  of  the  relative  strength 
of  these  opposing  factors.  No  special  attention  to  the  cyclical  char¬ 
acter  of  the  fluctuations  in  business  activity  is  involved,  except  that 
the  forces  engendered  by  any  given  stage  of  prosperity  which  make 
for  change  are  recognized  along  with  other  factors  which  originate 
elsewhere.  This  method  emphasizes  the  factors  which  differentiate 
every  situation  from  those  which  have  preceded  it. 

The  other  method  consists  of  a  statistical  study  of  the  records  of 
past  cycles  in  the  hope  of  establishing  laws  by  which  the  course  of  a 
given  cycle  can  be  predicted  by  observing  its  progress  and  assuming 
that  it  will  proceed  as  cycles  have  proceeded  in  the  past.  Advocates 
of  this  method  urge  that  the  regularities  observed  in  the  behavior 
of  certain  types  of  data  are  so  great  as  to  justify  forecasters  in  assum¬ 
ing  that  these  regularities  will  continue  to  show  themselves  in  the 
future. 

Fundamentally,  this  is  the  method  of  all  statistical  science;  the 
question  of  its  validity  in  connection  with  this  particular  problem 
hinges  on  the  degree  of  regularity  in  the  behavior  of  the  items  studied, 
the  length  of  time,  or  better,  the  number  of  complete  cycles,  through 
which  the  asserted  regularity  of  behavior  has  been  traced,  the  absence 
of  known  causes  which  may  reasonably  be  expected  to  alter  the 
sequence  of  phenomena  in  the  future,  and  the  availability  and  accu¬ 
racy  of  the  necessary  data.  In  the  following  sections,  the  leading 
barometric  items  are  described,  and  their  value  for  forecasting  pur¬ 
poses  is  estimated. 

Fluctuations  in  prices  are  generally  considered  to  constitute  the  central 
phenomenon  of  the  business  cycle.1 — Interest  centers  therefore  on 

*  For  a  survey  of  the  literature  of  the  cycle  in  which  this  point  is  developed  in 
detail,  cf.  J  H.  Williams,  “The  Rdle  of  Prices  in  the  Business  Cycle,”  Review  of 

Economic  Statistics ,  I,  206-10. 


BUSINESS  FORECASTING 


87 


attempts  to  forecast  the  course  of  prices  rather  than  to  use  them  to 
forecast  other  phenomena.  Indices  constructed  by  averaging  large 
numbers  of  prices,  however,  have  few  irregular  fluctuations,  hence 
a  definite  change  of  trend  usually  is  interpreted  to  forecast  a  consider¬ 
able  continued  movement  in  the  new  direction.  Prices  may  therefore 
be  said  without  great  inaccuracy  to  forecast  their  own  movements. 

To  show  the  trend  of  prices,  averages  known  as  index  numbers 
are  compiled.  Of  these,  the  most  widely  used  are  Bradstreet’s  and 
the  Bureau  of  Labor  Statistics’  indices.  Bradstreet’s  index  is  obtained 
by  simply  adding  together  the  prices  per  pound  of  ninety-six  commodi¬ 
ties.  This  index  is  published  monthly.  The  Bureau  of  Labor 
Statistics’  index  is  a  carefully  weighted  average  of  over  four  hundred 
prices,  each  of  which  has  been  reduced  to  a  percentage  of  the  average 
price  of  the  commodity  for  1913.  The  Bureau  of  Labor  index  is 
much  the  more  scientifically  constructed  of  the  two,  but  the  difference 
in  results  obtained  is  not  as  great  as  the  difference  in  methods  of 
compilation  would  lead  one  to  expect.  Bradstreet’s  index  tends  to 
precede  the  Bureau  of  Labor  index  in  both  its  upward  and  its  down¬ 
ward  turns,  because  it  contains  a  larger  proportion  of  prices  of  raw 
materials.  For  this  reason,  it  is  somewhat  more  useful  as  a  barometer 
of  general  business  conditions. 

The  volume  of  business  done  by  the  railways  is  a  good  barometer  of 
general  business  conditions ,  though  it  tends  rather  to  lag  behind  other 
indicators  than  to  precede  them.  The  figures  generally  used  are  those 
of  railway  gross  earnings,  idle  cars,  and  car  loadings.  Of  these,  the 
car  loadings  are  the  most  accurate  and  are  also  the  earliest  available. 
Unfortunately  they  are  only  available  for  the  last  few  years. 

Gross  earnings  are  a  good  indication  of  the  amount  of  business  done, 
provided  care  is  taken  not  to  overlook  the  effects  of  changes  in  freight 
rates.  For  example,  the  very  great  increase  in  railway  gross  income 
in  the  early  fall  of  1920  was  due  to  the  increase  in  rates  and  not  to 
any  increase  in  the  movement  of  goods,  except  the  normal  seasonal 
increase. 

Railway  earnings  generally  lag  a  month  or  two  behind  the  course 
of  general  business  on  a  downswing  for  the  reason  that  goods  which 
have  been  contracted  for  and  goods  which  are  drawn  on  the  market 
under  pressure  to  liquidate  keep  up  the  movement  of  freight  during, 
and  after,  the  crisis.  After  this  movement  has  spent  itself,  the  earn¬ 
ings  fall  off  sharply.  For  instance,  after  the  panic  of  1907,  which 
occurred  in  October  the  earnings  of  ten  leading  railroads  remained 


88 


RISK  AND  RISK-BEARING 


above  normal  until  December,  and  were  only  7  per  cent  below  normal 
in  January,  but  by  July  were  16  per  cent  below.  Again  in  1920  the 
decline  of  business  activity  was  not  reflected  in  the  railroads’  earnings 
until  late  in  the  fall,  though  prices  reached  their  maximum  in  the 
spring. 

Figures  for  net  earnings  of  railroads  receive  a  great  deal  of  atten¬ 
tion,  partly  because  increasing  prosperity  of  railroads  is  apt  to  result 
in  increased  purchases  of  equipment  and  construction  materials,  and 
the  volume  of  the  railroads  purchases  is  so  great  that  anything  which 
stimulates  or  depresses  their  buying  is  a  major  cause  of  prosperity 
or  depression  in  any  other  lines.  Another  reason  for  the  interest  in 
railroad  net  earnings  is  the  extremely  wide  investment  interests  in 
their  securities,  and  still  another  is  the  fact  that  changes  in  freight 
rates  are  forecast  by  the  movement  of  railroad  net  earnings.  Under 
the  present  law,  it  is  the  duty  of  the  Interstate  Commerce  Commission 
to  allow  the  railroads  to  collect  such  rates  as  will  yield  them  a  fair 
return  (at  present  figured  at  5^  per  cent)  on  the  appraised  value  of 
their  investment;  hence  a  large  increase  in  railroad  net  earnings 
creates  hope  of  lower  rates,  and  a  decline  in  them  dampens  that  hope. 

Idle  car  figures  are  not  very  accurate,  as  the  number  of  roads  report¬ 
ing  varies  and  the  figures  are  affected  by  activity  in  car-building  and 
repairing  cars,  as  well  as  by  changes  in  the  number  actually  used. 
In  spite  of  these  theoretical  defects,  the  figures  usually  show  much  the 
same  thing  as  the  other  transportation  data,  and  no  great  risk  is 
involved  in  using  them  if  they  happen  to  be  more  readily  available 
than  the  more  accurate  indices. 

Industrial  corporation  reports  furnish  little  barometric  assistance. — 
If  accurate  data  were  available  at  any  time  concerning  the  volume 
of  business  and  the  profit  margins  at  which  the  leading  business  cor¬ 
porations  o'f  the  country  are  doing  business,  the  information  would  be 
of  incalculable  value  in  gauging  the  outlook  for  good  or  bad  business. 
A  clearing-house  for  the  free  exchange  of  such  information  with 
power  to  compel  full  and  accurate  statements  would  be  of  very  great 
service  to  its  members.  The  impossibility  of  securing  such  an  inter¬ 
change  illustrates  one  of  the  disadvantages  of  a  competitive  system. 
Each  firm  has  something  to  lose  by  imparting  a  full  knowledge  of  its 
condition  to  its  competitors,  for  even  though  it  might  gain  much  more 
than  it  would  lose  if  it  obtained  full  knowledge  of  their  condition  in 
the  exchange,  each  would  gain  still  more  by  securing  the  information 
from  the  others  without  making  public  the  true  facts  concerning  its 


BUSINESS  FORECASTING 


89 


own  condition,  thus  securing  the  benefit  of  the  general  publicity  while 
protecting  its  own  business  secrets.  This  being  the  case,  no  firm  is 
willing  to  be  the  first  to  abandon  its  policy  of  protecting  business 
secrets  and  each  would  be  suspicious  of  any  other  which  offered  to  do 
so.  The  result  is  that  business  is  done  largely  in  ignorance  of  the 
extent  to  which  competitors  are  piling  up  stocks  of  goods  in  anticipa¬ 
tion  of  the  same  demand,  accepting  duplicate  orders  and  planning 
expansions  which  conflict  with  other  producers’  calculations  of  the 
extent  of  the  market  and  the  supply  of  labor  and  raw  materials  which 
will  be  available  for  themselves. 

A  possible  way  out  of  the  dilemma  is  the  imparting  of  confidential 
information  to  a  public  or  private  statistical  bureau  with  the  under¬ 
standing  that  the  results  will  be  published  only  in  the  form  of  totals 
or  averages,  or  otherwise  so  treated  as  not  to  indicate  the  position  of 
individual  firms.  Much  progress  has  been  made  by  various  agencies 
in  the  last  few  years  in  obtaining  the  co-operation  of  business  men  in 
such  endeavors.  Examples  are  the  studies  of  retailers’  costs  made  by 
the  Harvard  Bureau  of  Business  Research;  the  data  on  volume  of 
current  production  and  stocks  of  goods  published  monthly  by  the 
Department  of  Commerce  in  the  Survey  of  Current  Business;  and 
numerous  surveys  of  particular  industries  published  by  trade  journals. 
Open  price  associations  have  also  done  something  to  reduce  the  amount 
of  uncertainty  concerning  the  business  outlook,  but  such  organiza¬ 
tions  find  it  diffcult  to  steer  clear  of  the  antitrust  laws.  Further 
progress  along  this  line,  it  is  to  be  hoped,  will  afford  a  better  means 
than  we  now  have  for  reducing  the  irregularities  of  business  activity. 

Aside  from  the  data  given  out  in  this  way,  the  principal  information 
available  concerning  the  prosperity  of  individual  corporations  is 
found  in  the  annual  or  more  frequent  reports  of  income  and  statements 
of  assets,  the  reports  of  business  failures,  and  changes  of  dividends. 
To  each  of  these,  consideration  will  be  given. 

The  reports  of  industrial  corporations  concerning  their  activities 
are  issued  so  infrequently,  and,  as  a  rule,  so  long  after  the  period  to 
which  they  refer  that  they  are  of  little  value  as  indices  of  the  general 
business  situation,  though  they  are  very  valuable  as  records  of  the 
course  which  prosperity  and  depression  have  taken  in  the  past.  Even 
in  the  case  of  corporations  which  issue  quarterly  statements  of  earn¬ 
ings,  the  information  is  delayed  to  such  an  extent  that  it  usually  is 
of  value  only  to  investors  or  speculators  who  are  dealing  in  the  securi¬ 
ties  of  the  individual  corporation,  and  not  to  the  student  of  the  general 


go 


RISK  AND  RISK-BEARING 


situation.  Moreover,  the  reports  of  corporations  are  so  apt  to  be 
colored  by  the  interest  of  the  management  in  making  a  showing  of 
prosperity  or  of  poverty  that  they  must  be  used  with  caution. 

The  foregoing  generalizations  have  no  application  to  the  railroads. 
Railway  earnings  are  published  monthly,  and  uniform  accounting 
methods  are  prescribed  by  the  Interstate  Commerce  Commission  so 
that  the  results  for  different  roads  and  for  different  periods  are  com¬ 
parable. 

Dividend  payments  are  even  less  reliable  than  statements  of  net  earn¬ 
ings  as  indications  of  business  conditions ,  because  changes  in  dividends 
lag  far  behind  the  changes  in  business  conditions  which  cause  them. 
This  is  particularly  true  of  the  relation  of  dividend  increases  to  busi¬ 
ness  recovery.  Reduction  or  passing  of  dividends  follows  more 
promptly  on  a  collapse  of  prosperity,  but  so  far  as  the  general  situa¬ 
tion  is  concerned  it  tells  only  what  is  already  known.  Investors  are 
of  course  very  directly  interested  in  the  passing  of  dividends  by  corpora¬ 
tions  whose  securities  they  own,  but  the  action  of  one  company  is  of 
little  value  as  a  forecast  of  what  another  company  will  do. 

Numerous  increases  of  dividend  rates  and  the  declaration  of  extra 
dividends  are  often  considered  to  be  a  sign  of  better  days  ahead, 
but  such  an  interpretation  is  more  likely  than  not  to  be  incorrect. 
When  business  is  increasing  relatively  few  concerns  find  it  good  policy 
to  make  extra  large  disbursements.  Rather  they  reinvest  their  earn¬ 
ings  to  provide  facilities  for  taking  care  of  their  expanding  volume  of 
business.  It  is  at  the  end  of  a  period  of  prosperity  when  large  profits 
have  been  accumulated  and  there  is  no  prospect  of  their  being  needed 
for  further  expansion  that  good  policy  permits  the  declaration  of 
abnormally  large  dividends. 

Moreover,  the  dividend  policies  of  corporations  seem  frequently 
to  be  regulated  with  a  view  to  promoting  the  interest  of  insiders  in 
stock-market  dealings,  and  extra  dividends  in  the  closing  days  of 
prosperity  are  an  excellent  device  for  strengthening  the  market  until 
stocks  can  be  distributed. 

Business  failures  area  useful  barometer. — Monthly  figures  for  com¬ 
mercial  failures  are  published  by  Dun's  Review  and  Bradstreet's,  and 
these  are  quite  widely  reprinted.  These  are  failures  involving  losses 
to  creditors.  There  are  no  statistics  of  industrial  failures  and  none 
for  failures  which  result  only  in  the  loss  of  the  owners’  capital.  The 
figures,  both  those  for  number  of  failures  and  those  for  total  liabilities, 
show  a  high  degree  of  correspondence  with  the  activity  of  general 


BUSINESS  FORECASTING 


91 


business.  Failures,  which  are  at  a  minimum  in  the  latest  stages  of 
prosperity,  increase  very  suddenly,  reach  the  maximum  while  liquida¬ 
tion  is  at  its  height,  then  decrease  gradually  through  the  following 
periods  of  depression,  recovery,  and  prosperity.  Since  1890  the  pro¬ 
portion  of  concerns  failing  has  ranged  from  .38  of  1  per  cent  in  1919 
to  1.32  in  1915.1 

Bradstreet’s  classifies  its  data  according  to  the  causes  of  failure, 
such  as  incompetence,  lack  of  capital,  competition,  etc.,  giving  annu¬ 
ally  the  percentage  which  is  accounted  for  by  each  cause.  The  classi¬ 
fication  has  no  apparent  value  for  barometric  purposes;  indeed,  it  is 
so  vague  that  most  failures  could  properly  be  classified  under  two  or 
more  captions.  There  is  a  pronounced  seasonal  variation  in  the 
statistics,  January  having  by  far  the  most  failures,  and  December 
ranking  second. 

Business  failures  form  a  convenient  and  readily  accessible  indica¬ 
tion  of  the  degree  of  prosperity.  Their  chief  defect  as  a  forecaster 
is  that  their  increase  comes  abruptly  at  a  time  when  liquidation  is 
already  obvious,  while  their  decreases  are  so  gradual  that  it  is  difficult 
to  judge  when  the  number  is  approaching  a  minimum. 

New  security  issues  show  some  effect  of  the  business  cycle ,  but  are  of 
no  particular  interest  as  barometers. — In  times  of  prosperity,  stock 
issues  predominate.  In  the  earlier  part  of  a  depression,  there  are 
numerous  bond  issues  designed  to  enable  the  issuers  to  pay  off  their 
bank  loans.  Many  of  these  bond  issues  are  of  a  highly  speculative 
character.  Later  in  the  depression  period,  high-grade  bond  issues 
are  brought  out  by  strong  corporations  in  order  to  refund  short-term 
notes  and  callable  bonds  at  the  low  rates  then  prevailing.  These 
changes,  however,  merely  reflect  the  changes  in  the  rate  of  interest 
and  in  public  confidence,  and  nothing  is  added  to  our  understanding 
of  the  current  situation  by  tabulating  them  for  study. 

Statistics  of  the  iron  and  steel  trade  are  given  a  great  deal  of  attention 
by  students  of  the  trend  of  business. — This  is  true  because  of  the  extent 
to  which  activity  in  the  production  of  iron  and  steel  is  essential  to 
activity  in  the  production  of  almost  everything  else.  Building  of 
every  kind,  the  construction  of  railways  and  of  railway  equipment, 
the  manufacture  of  agricultural  implements  and  of  nearly  all  kinds 
of  machinery,  all  make  heavy  demands  on  the  steel  capacity  of  the 
country,  so  that  a  marked  increase  or  decrease  in  the  activity  of  almost 
any  industry  is  reflected  in  the  orders  for  iron  and  steel. 

1  Dun's  Review,  XXIX,  18-19,  quoted  by  Jordan,  Business  Forecasting,  p.  159. 


92 


RISK  AND  RISK-BEARING 


For  recent  years,  statistics  of  this  industry  are  available  in  great 
variety,  but  those  to  which  most  attention  is  given  are  the  figures 
for  the  production  and  price  of  pig  iron  and  the  unfilled  orders  of  the 
United  States  Steel  Corporation.  Of  these,  the  most  useful  are  the 
figures  for  pig-iron  production.  Pig-iron  production  conforms  quite 
closely  in  its  fluctuations  to  the  movement  of  the  business  cycle  as 
indicated  by  other  barometers.  Normally,  its  fluctuations  are  con¬ 
current  with,  or  slightly  in  advance  of,  the  major  changes  in  prices. 
In  the  cycle  of  1919-21,  however,  pig  iron  lagged  far  behind  the  course 
of  general  business,  reaching  a  minimum  in  the  autumn  of  1919  and 
a  maximum  in  the  autumn  of  1920,  some  eight  months  after  Brad- 
street’s  index  in  each  case.  This  irregularity,  at  least  so  far  as  the 
low  figure  for  1919  is  concerned,  is  to  be  accounted  for  by  the  strike 
in  the  plants  of  the  United  States  Steel  Corporation. 

Pig-iron  prices  move  in  fairly  close  conformity  with  the  fluctua¬ 
tions  in  business,  but  they  are  so  largely  subject  to  control  in  accord¬ 
ance  with  the  judgment  of  a  few  individuals  that  they  are  less  trust¬ 
worthy  as  business  indices  than  are  production  figures. 

The  unfilled  orders  of  the  United  States  Steel  Corporation,  pub¬ 
lished  quarterly  from  1901  to  1910  and  monthly  since  that  date,  move 
in  close  conformity  to  the  changes  in  the  production  of  pig  iron, 
normally,  however,  changing  a  trifle  earlier.  In  theory,  orders  should 
be  an  earlier  index  of  coming  changes  than  production,  but  the  number 
of  unfilled  orders  is  so  affected  by  changes  in  the  rate  of  production, 
quite  apart  from  changes  in  demand,  that  the  priority  of  movement 
is  not  uniform  and  the  significance  of  the  figures  is  not  always  clear. 

Agricultural  production  gives  no  clear  indication  of  the  business  out¬ 
look. — The  influence  of  agricultural  production  is  perhaps  the  most 
difficult  factor  to  analyze  in  the  whole  problem  of  the  coming  and  going 
of  prosperity.  The  difficulty  does  not  arise,  however,  from  the  lack 
of  information,  for  we  have  not  only  excellent  statistical  data  concern¬ 
ing  the  volume  of  output  and  the  prices  of  leading  agricultural  prod¬ 
ucts  but  also  frequent  forecasts  throughout  the  crop  year,  some 
compiled  by  private  agencies  and  some  by  the  Federal  Department 
of  Agriculture.  The  difficulty  arises  from  the  apparent  lack  of  cor¬ 
respondence  between  the  actual  relations  of  agricultural  production 
and  business  prosperity  and  the  relations  which  economic  theory 
lead  us  to  expect.  Nearly  all  those  who  have  written  on  the  subject 
of  the  business  cycle  have  agreed  in  emphasizing  the  fundamental 
importance  of  crops  in  determining  the  prosperity  of  general  business. 


BUSINESS  FORECASTING 


93 


The  generally  accepted  doctrine  has  been  well  summarized,  for 
instance,  by  J.  H.  Brookmire: 

Crops  affect  business:  (i)  by  directly  determining  the  ability  of  the 
farmer  to  buy  factory  products,  his  annual  purchasing  power  through 
crops  amounting  to  about  $9,000,000,000;  (2)  by  indirectly  determining 
the  amount  of  merchandise  which  persons  employed  in  manufacturing  and 
mercantile  lines  and  all  other  non-agricultural  pursuits  can  purchase,  for 
if  they  must  pay  high  prices  for  food  there  will  be  less  to  spend  for  mer¬ 
chandise,  and  vice  versa;  (3)  by  determining  the  earnings  of  the  railroads, 
for  railroad  traffic  largely  consists  in  hauling  farm  products  or  merchandise 
to  be  exchanged  for  farm  products,  and  since  the  crops  largely  determine  the 
ability  of  the  railroads  to  buy  new  equipment  and  make  improvements,  it 
follows  that  crops  thus  indirectly  determine  the  degree  of  prosperity  in 
the  iron  and  steel  business,  which  is  the  basic  industry  of  the  country. 
Thus  it  is  evident  that  activity  in  transportation,  iron  and  steel,  hardware, 
textiles  and  all  other  lines  of  business  finds  its  stimulative  source — its 
fountain-head — in  the  agricultural  harvests  of  the  country.  Prosperity 
fundamentally  depends  upon  the  condition  of  the  soil,  and  the  business  men 
of  this  country  always  adjust  their  commercial  commitments  to  the  pros¬ 
pects  of  the  harvests  to  a  greater  extent  than  to  any  other  one  factor . 1 

Mitchell  is  less  emphatic,  but  says,  “good  crops  tend  to  bring 
prosperity  and  poor  crops  depression  in  the  seasons  which  follow. 
But  the  numerous  exceptions  to  this  rule  show  that  other  factors 
often  overbalance  the  effect  of  the  harvests.”2 

The  theory  above  outlined  seems  sound.  That  abundant  agri¬ 
cultural  production  is  fundamental  to  the  prosperity  of  the  American 
people  can  scarcely  be  questioned,  for  nearly  a  third  of  our  employed 
population  are  engaged  in  agriculture  and  a  large  proportion  of  the 
rest  are  in  business  which  caters  directly  to  the  needs  of  the  farmer. 
Moreover,  more  than  half  of  the  raw  materials  used  in  our  manufac- 
tures  are  products  of  the  farm.  Short  crops  apparently  mean  hard¬ 
ship  for  the  farmer,  reduced  earnings  for  the  railroad,  lighter  employ¬ 
ment  for  the  railroad  workers,  higher-priced  and  scarcer  raw  materials 
for  the  manufacturer,  and  higher  costs  of  living  for  the  people,  with¬ 
out  an  offsetting  gain  for  anyone. 

And  yet  it  is  impossible  to  find  in  our  business  history  any  con¬ 
firmation  of  such  a  view.  Neither  as  cause  nor  as  effect  do  the  lead- 

1  J.  H.  Brookmire,  “Financial  Forecasting,”  Moody's  Magazine ,  XVI  (1913), 
19-21. 

2  Business  Cycles,  p.  239.  See  also  for  similar  views  Jordan,  Business  Fore¬ 
casting,  p.  80;  Jones,  Investments,  p.  256. 


04 


RISK  AND  RISK-BEARING 


ing  crops  appear  to  be  related  consistently  to  the  fluctuations  of  busi¬ 
ness  activity.  It  is  true  that  in  1879  and  in  1891  good  crops  sold  at 
high  prices  on  account  of  the  foreign  crop  failure  proved  a  direct  and 
unmistakable  stimulus  to  American  business.  In  1921,  moreover, 
the  business  depression  reacted  so  unfavorably  on  the  position  of  the 
farmer  through  decrease  in  agricultural  prices  as  to  cause  a  startling 
curtailment  in  farmers’  buying,  which  in  turn  struck  heavy  blows  at 
the  prosperity  of  not  only  all  mail-order  houses,  implement  manu¬ 
facturers,  and  fertilizer  companies,  but  of  every  line  of  business  whose 
sales  territory  was  in  the  West  or  South.  But,  as  a  rule,  no  such  con¬ 
nection  between  crops  and  prosperity  can  be  traced.  The  fluctua¬ 
tions  in  the  curves  of  cotton,  corn,  and  wheat  production  rarely  coin¬ 
cide,  and  when  they  do,  they  do  not  forecast  corresponding  changes 
in  general  business.  Cotton  and  wheat  production  were  both  unusu¬ 
ally  large  in  1898,  declined  greatly  in  1899,  and  recovered  in  the  years 
immediately  following;  improvement  and  prosperity  were  unbroken 
from  1897  to  1903.  All  the  major  crops  declined  in  volume  in  1903, 
and  depression  followed  in  1904,  but  they  all  increased  in  1906  to 
practically  the  highest  figures  known  up  to  that  time,  and  though 
they  were  somewhat  smaller  in  1907,  were  still  above  normal  in  that 
year,  yet  a  severe  depression  began  at  the  end  of  1907. 

The  explanation  of  this  lack  of  harmony  between  the  results  of 
observation  and  those  anticipated  from  the  standpoint  of  theory  is 
somewhat  obscure.  It  must  be  remembered  however  that  very  large 
or  very  small  crops  of  all  the  leading  agricultural  commodities  seldom 
occur  in-  the  same  year,  so  that  a  shortage  in  cotton  is  very  likely  to 
offset,  to  a  large  extent,  the  effect  of  a  bumper  crop  of  wheat,  and 
vice  versa.  It  must  be  borne  in  mind  also  that  the  purchasing 
power  of  the  farmer  depends  not  on  the  size  but  on  the  value  of  his 
crop,  and  that  a  rise  in  prices  usually  offsets  part  of  his  loss  from  a 
short  crop.  Indeed  sometimes,  especially  in  the  case  of  cotton,  the 
increase  in  prices  more  than  offsets  the  loss  in  production.  In  1914, 
an  enormous  cotton  crop  sold  at  bottom  prices  caused  almost  a  col¬ 
lapse  of  the  whole  economic  structure  of  the  South,  while  in  1921  a 
short  crop  was  hailed  with  delight  as  promising  relief  from  the  prevail¬ 
ing  depression.  This  does  not  mean  that  the  loss  from  short  produc¬ 
tion  is  less  than  it  would  be  if  prices  were  not  affected  by  the  size  of 
the  crop.  What  the  farmer  gains  by  high  prices  someone  else  always 
loses;  what  he  loses  by  short  crops  no  one  else  gains.  But  the  high 
prices  do  mean  that  the  loss  from  short  crops  is  in  part  shifted  to  for- 


BUSINESS  FORECASTING 


95 


/ 


eign  nations,  in  part  diffused  among  a  larger  group  in  this  country,  and 
in  part  distributed  into  succeeding  years  through  a  reduction  in  the 
carry  over.  The  loss  from  higher-priced  raw  materials  is  largely  ab¬ 
sorbed  in  corporation  profits  without  necessitating  changes  in  divi¬ 
dend  rates,  or  carried  into  prices  of  manufactured  goods  which  are 
not  finally  sold  until  later  years,  and  are  in  part  sold  abroad. 

The  loss  to  the  railroads  from  crop  failure  is  genuine,  but  its  impor¬ 
tance  is  much  less  than  it  was  a  generation  ago.  No  important  rail¬ 
road  is  now  dependent  solely  on  agricultural  production  for  its  traffic. 
Even  such  a  highly  specialized  grain-carrying  road  as  the  Missouri, 
Kansas,  and  Texas  collects  less  than  one-fourth  of  its  freight  revenue 
from  products  of  the  farm.  Moreover,  such  effect  as  the  short  crop 
does  have  is  distributed  through  several  years.  Less  labor  is  employed 
in  transportation  of  crops  in  the  year  in  which  the  shortage  occurs; 
equipment  purchases  are  more  likely  to  be  reduced  in  the  following 
year. 

Thus  throughout  the  industrial  structure,  the  influence  of  several 
crop  years  gets  averaged,  some  parts  of  the  country  and  some  lines 
of  business  feeling  the  effect  of  one  year’s  short  crop  while  others  are 
feeling  the  effects  of  another  year’s  good  crop,  and  the  effect  on  general 
business  activity  of  any  particular  crop  becomes  so  blurred  that  it  is 
quite  hopeless  to  try  to  draw  any  conclusions  from  the  crops  as  to 
the  outlook  for  business  in  general. 

All  this  is  not  to  say,  however,  that  the  crop  outlook  is  of  no  baro¬ 
metric  significance.  It  simply  means  that  the  crops  are  among  the 
things  which  cause  one  business  and  one  section  to  prosper  while 
another  is  depressed,  rather  than  the  things  which  determine  the 
tidal  swings  of  the  market  as  a  whole.  Each  business  man  has  to 
study  not  only  the  outlook  for  business  in  general  but  also  the  factors 
which  affect  peculiarly  the  lines  of  business  and  the  locality  in  which 
he  is  interested  and  make  its  outlook  different  from  that  of  business  as 
a  whole.  In  this  latter  task,  a  study  of  the  crop  outlook  is  likely  to  be 
of  primary  importance. 

Stock  prices  have  a  high  reputation  as  business  barometers. — The 
stock  exchanges  of  the  country  all  publish  daily  records  of  the  high¬ 
est  and  lowest  prices  paid  fo~  each  security,  together  with  the  number 
of  shares  sold,  and  numerous  averages  of  the  prices  of  selected  lists 
of  stocks  are  published  by  periodicals  and  financial  services. 

In  general,  stock  prices,  particularly  prices  of  industrial  stocks, 
are  among  the  first  prices  to  rise  and  also  the  first  to  fall,  in  the  course 


96 


RISK  AND  RISK-BEARING 


of  a  business  cycle.  It  is  for  this  reason  that  so  high  an  estimate 
is  placed  upon  their  barometric  significance.  For  instance,  before 
the  crisis  of  1907  stock  prices  showed  a  downward  trend  from  Janu¬ 
ary,  1906,  and  before  the  crisis  of  1920  they  turned  downward  in 
November,  1919.  Likewise  in  1904,  1908,  1915,  and  1921  they 
turned  upward  from  four  to  eight  months  before  the  appearance  of 
rising  commodity  prices  and  increased  business  activity. 

Much  caution  is  necessary  in  using  stock  prices  as  an  index  of  the 
business  trend,  however,  for  the  reason  that  the  stock  market  has 
many  minor  fluctuations  which  are  quite  independent  of  the  course 
of  business  in  general.  Hence  it  is  necessary  after  a  change  in  the 
trend  of  stock  prices  to  wait  for  some  weeks  to  see  whether  there  has 
occurred  a  real  reversal  of  trend  or  only  a  minor  fluctuation.  More¬ 
over,  even  the  major  changes  in  stock  prices  are  not  always  followed 
by  similar  changes  in  commodity  prices  and  business  activity,  though 
changes  in  business  activity  seem  always  to  be  preceded  by  similar 
changes  in  the  trend  of  stock  prices.  For  instance,  in  1899  and  1900, 
in  1910,  and  in  1917  major  declines  in  the  stock  market  gave  warning 
of  similar  declines  in  other  indices  of  prosperity,  but  no  such  declines 
occurred. 

The  most  reliable  and  hence  the  most  important  group  of  business 
barometers  is  the  group  which  relates  to  the  money  market. — Credit  is  the 
life-blood  of  modern  business,  and  the  banking  system  constitutes  the 
circulatory  apparatus  through  which  credit  is  made  available  for  the 
more  directly  productive  parts  of  the  industrial  organism.  Hence, 
irregularities  in  the  operation  of  the  banking  system  are  as  significant 
to  the  student  of  industrial  ills  as  are  irregularities  in  the  pulse  beat 
to  the  physician. 

Banking  barometers  fall  into  three  principal  classes:  indices  of 
the  volume  of  business  transacted,  of  which  the  clearings  and  the 
checks  cashed  are  the  most  important;  statements  of  the  condition 
of  the  banks,  including  the  weekly  reports  of  the  Federal  Reserve 
System,  the  reports  of  the  Comptroller  of  the  Currency  on  the  condi¬ 
tion  of  national  banks,  and  the  reports  of  state  banks  and  trust  com¬ 
panies;  and  finally  rates  of  interest  on  various  classes  of  loans. 

Bank  clearings  and  check  transactions  furnish  a  measure  of  the  activity 
of  business  in  the  country ,  hence  are  more  significant  as  general  business 
barometers  than  as  indices  of  the  position  of  the  banks.  For  compari¬ 
sons  extending  over  a  considerable  period  of  time,  the  best  index  of 
the  volume  of  payments  is  the  record  of  clearings.  These  figures 


BUSINESS  FORECASTING 


97 


are  collected  by  the  Commercial  and  Financial  Chronicle  and  by 
Bradstreefs.  For  the  last  few  years  the  figures  of  individual  debits 
at  member  banks  have  been  collected  by  the  Federal  Reserve  Board. 
This  is  the  figure  for  the  total  number  of  checks  cashed  and  other 
charges  made  against  individuals’  accounts,  and  is  a  more  accurate 
index  than  the  clearings,  which  include  only  checks  deposited  in 
banks  other  than  the  ones  on  which  drawn,  and  omit  a  considerable 
proportion  even  of  these.  When  the  individual  debits  have  been 
collected  for  a  sufficiently  long  period  to  make  significant  compari¬ 
sons  possible  they  will  presumably  supplant  the  clearings  for  fore¬ 
casting  purposes.  There  appears  to  be  little  difference  in  the  direction 
and  relative  amount  of  the  changes  indicated  by  the  two  barometers, 
however. 

In  using  bank  clearings  as  a  barometer  of  general  business,  it  is 
customary  to  omit  the  figures  for  New  York  City,  on  account  of  the 
large  influence  exerted  on  those  figures  by  changes  in  the  volume  of 
speculation  at  the  Stock  Exchange.  Outside  clearings  fluctuate,  in 
general,  in  much  the  same  way  as  pig-iron  production,  wholesale 
prices,  and  business  failures;  that  is,  they  give  a  fairly  consistent 
picture  of  the  changes  in  the  volume  of  business  transacted,  but  do  not 
anticipate  changes  in  such  a  way  as  to  give  them  any  marked  superi¬ 
ority  over  the  other  standard  indices. 

Statements  of  condition  of  the  banks  are  more  diffictdt  of  interpreta¬ 
tion  than  they  were  before  the  introduction  of  the  Federal  Reserve  System. 
— In  former  days,  when  the  national  banks  were  required  to  keep  in 
their  vaults  a  definite  proportion  of  their  deposits  in  lawful  money, 
the  surplus  reserve  over  this  requirement,  particularly  the  surplus 
reserve  of  the  New  York  banks,  was  regarded  as  one  of  the  most 
sensitive  barometers  of  financial  weather.  Since  the  introduction 
of  the  Federal  Reserve  System,  attention  has  been  shifted  to  the 
reserve  ratio  of  the  Federal  Reserve  banks.  This  item  cannot  be 
interpreted  with  the  facility  with  which  the  surplus  reserve  of  former 
days  was  interpreted,  because  of  the  extent  to  which  the  control 
of  Federal  Reserve  credit  resources  is  exercised  in  accordance  with 
the  judgment  of  a  small  number  of  individuals.  If  it  were  certain 
that  the  Federal  Reserve  Board  would  in  the  future  be  guided  by  the 
Federal  Reserve  ratio  in  determining  its  credit  policy  in  the  way  that 
directors  of  competing  banks  were  guided  by  their  reserve  ratios  before 
the  Federal  Reserve  System  was  established,  the  ratio  of  cash  reserves 
to  combined  notes  and  deposits  of  the  twelve  banks  would  be  better 


98 


RISK  AND  RISK-BEARING 


worth  watching  than  any  single  index  which  can  be  obtained.  But  the 
Federal  Reserve  Board  is  a  body  with  large  discretion  and  has  a 
responsibility  to  administer  the  affairs  of  the  system  with  a  view  to 
the  public  interest  rather  than  with  a  view  to  earning  the  largest 
profits  consistent  with  safety,  and  the  element  of  personal  judgment 
makes  their  action  difficult  to  forecast.  So  far,  the  rise  and  fall  of 
the  combined  ratio  has  seemed  to  be  their  most  important  guide, 
but  there  is  no  assurance  that  it  will  continue  to  be  so. 

Fluctuations  in  such  items  as  total  gold  reserve ,  national  bank 
notes  outstanding ,  Federal  Reserve  notes  outstanding ,  and  data  relative 
to  fiscal  operations  of  the  government  are  now  of  little  barometric 
importance.  Total  bills  discounted  is  an  item  of  more  significance, 
as  it  shows  the  extent  to  which  the  banks  are  using  the  rediscounting 
privilege,  and  thereby  indicates  the  extent  to  which  interest  rates 
in  the  near  future  are  likely  to  be  controlled  by  the  policy  of  the 
Federal  Reserve  Board.  Turnover  of  bank  deposits  is  a  new  statistical 
item,  collected  by  the  Federal  Reserve  Board  from  a  limited  number 
of  banks,  which  promises  to  be  of  considerable  value  as  an  index  of 
business  activity,  but  is  not  yet  available  for  a  sufficiently  long  period 
to  make  careful  comparative  study  of  its  behavior  feasible. 

The  most  valuable  single  indices  of  busmess  conditions  are  found  in  the 
rates  of  interest. — This  is  true  partly  because  of  the  abundance  and 
accuracy  of  the  data,  partly  because  of  the  consistency  with  which 
changes  in  the  money  market  precede  changes  in  general  business, 
and  partly  because  the  part  played  by  money-market  conditions  in 
causing  changes  in  prosperity  is  great  enough  to  make  it  possible  to 
make  allowance  for  exceptional  conditions  more  readily  than  is 
possible  in  using  forecasters  whose  relationship  to  the  phenomena 
forecast  is  purely  empirical. 

Our  statistical  information  in  regard  to  the  prices  charged  for 
the  services  of  capital  is  very  satisfactory.  Data  are  available 
for  a  large  number  of  kinds  of  financial  transactions,  and  most  of  the 
information  appears  quite  promptly,  so  that  the  external  difficulties 
in  the  way  of  the  forecaster  are  at  a  minimum  in  working  with  this 
type  of  barometer. 

The  interest  rates  which  receive  the  most  attention  from  a  baro-  . 
metric  standpoint  are  ( a )  the  yield  on  high-grade  bonds;  ( b )  the  rate  on 
prime  commercial  paper  (i.e.,  notes  bought  from  business  houses  by 
note  brokers  and  sold  to  banks);  (c)  the  rate  on  thirty -,  sixty-,  and 
ninety-day  loans  “  over  the  counter  ”  (i.e.,  direct  by  banks  to  their  own 


BUSINESS  FORECASTING 


99 


customers);  ( d )  the  Federal  Reserve  rediscount  rate;  (e)  the  call-loan 
rate . 

The  rates  on  brokers’  paper  and  those  on  short-time  loans  over  the 
counter  correspond  very  closely  in  the  direction  and  time  of  their 
changes,  so  that  one  will  serve  as  well  as  the  other  for  forecasting 
purposes. 

In  general,  all  interest  rates  rise  very  late  in  a  period  of  improve¬ 
ment  or  prosperity,  reach  their  maximum  during,  or  soon  after,  a 
crisis,  and  decline  only  after  the  liquidating  process  is  fairly  well 
completed.  Call  loans  show  by  far  the  widest  range  of  variation, 
and  change  the  most  frequently.  They  have  many  ups  and  downs 
which  are  not  connected  with  changes  in  the  activity  of  business. 
Bond  yields  are  at  the  other  extreme,  showing  comparatively  little 
change,  as  a  rule,  except  in  periods  of  very  great  change  in  business 
conditions.  Rates  on  short-term  paper  are  intermediate  in  character, 
and  are  excellent  indices  of  the  trend  of  business  conditions.  They 
move  so  late  in  the  cycle  as  to  forecast  a  turn  of  other  indices  in  the 
opposite  direction.  When  they  turn  definitely  either  up  or  down  after 
a  long  trend  in  the  other  way,  a  change  in  commodity  prices  and  busi¬ 
ness  activity  in  the  opposite  direction  may  generally  be  expected  within 
a  few  months.  Bond  prices  are  also  a  fairly  good  barometer.  When 
the  average  price  of  a  selected  group  of  high-grade  bonds  changes  the 
direction  of  its  trend,  there  generally  follows  a  like  movement  in  the 
stock  market,  and  less  uniformly,  there  ensues  a  few  months  later  a 
similar  change  in  commodity  prices  and  the  volume  of  business. 

Changes  in  the  Federal  Reserve  rediscount  rate,  i.e.,  the  rate 
charged  by  the  Federal  Reserve  banks  to  their  members  in  rediscount¬ 
ing  loans,  are  perhaps  destined  some  day  to  rank  as  the  most  impor¬ 
tant  indicators  of  the  trend  of  money-market  conditions  and  the 
consequent  outlook  for  business  prosperity,  but  we  have  had,  as  yet, 
too  little  experience  with  the  Federal  Reserve  System  to  enable  us  to 
lay  down  any  final  rules  for  interpreting  this  index.  The  object 
aimed  at  in  establishing  the  system  was  that  most  of  the  elasticity  of 
credit  in  the  banking  system  should  be  in  a  central  reservoir  of  credit, 
so  that  the  member  banks  would  have  to  resort  to  this  central  agency 
in  times  of  expanding  buxines?  in  order  to  take  care  of  the  increasing 
demands  of  their  customers.  In  line  with  this  purpose,  it  is  held  that 
any  increase  in  rates  or  restriction  of  credit  initiated  by  the  Federal 
Reserve  Board  will  radiate  through  the  system  and  cause  a  corre¬ 
sponding  rise  in  rates  and  curtailment  of  credit,  which  will  check  the 


TOO 


RISK  AND  RISK-BEARING 


expansion  of  business.  It  is  the  function  of  the  Federal  Reserve 
Board  to  keep  an  eye  on  the  progress  of  business  and  check  inflation 
before  it  reaches  the  point  where  a  collapse  is  inevitable.  Vice 
versa,  in  times  when  business  is  dull  the  Federal  Reserve  Board  can 
supply  a  stimulus  by  lowering  rates  and  encouraging  expansion 
through  a  liberal  rediscounting  policy. 

To  the  extent  that  the  banks  of  the  country  become  dependent 
on  the  privilege  of  rediscounting  their  customers’  notes  at  the  Federal 
Reserve  bank,  it  is  clear  that  there  do  exist  great  possibilities  of  con¬ 
trolling  the  course  of  business  through  control  of  the  supply  of  credit. 
At  the  height  of  the  boom  in  the  autumn  of  1919,  it  was  announced 
that  an  increase  in  the  discount  rate  could  be  expected  in  the  near 
future,  and  this  was  apparently  one  of  the  important  causes  of  the 
decline  in  stock  prices  which  started  in  November  of  that  year.  The 
rate  was  actually  increased  in  January  and  again  in  June  of  1920,  and 
it  is  generally  believed  that  this  action  was  one  of  the  major  causes 
of  the  commodity  liquidation,  which  was  evidenced  by  the  downward 
turn  of  Bradstreet’s  index  in  February  of  1920,  and  of  the  credit 
collapse  which  followed. 

As  our  analysis  of  the  cycle  in  chapter  v  has  indicated,  there  is  a 
considerable  amount  of  exaggeration  in  this  view,  though  it  contains 
a  large  element  of  truth.  The  speculative  accumulation  of  securities 
and  commodities  in  anticipation  of  further  and  further  increases  in 
price,  and  the  continuous  expansion  of  certain  types  of  productive 
capacity,  could  not  continue  indefinitely,  and  the  decline  once  started 
was  bound  to  gain  momentum.  But  it  was  in  the  power  of  the  Federal 
Reserve  Board  to  hasten  by  positive  action  the  downward  turn  which 
it  could  not  prevent  by  keeping  its  hands  off. 

On  the  other  hand,  the  power  of  the  Board  to  hasten  the  return  of 
prosperity  by  lowering  discount  rates  is  not  so  clear.  The  rate  was 
reduced  twice  in  1921  without  stimulating  any  considerable  increase 
in  rediscounting,  so  that  any  effect  the  reduction  had  in  stimulating 
business  must  have  been  sentimental.  The  difficulty  in  the  way  of 
stimulating  a  rise  is  very  much  greater  than  that  involved  in  checking 
a  rise.  When  business  is  active  the  banks  are  led  to  utilize  their  own 
resources  and  are  put  in  a  position  of  dependence  on  the  rediscounting 
agency.  In  a  period  of  depression,  however,  they  have  unused 
resources  of  their  own,  and  are  in  a  position  to  take  care  of  a  con¬ 
siderable  increase  in  customers’  demands  without  borrowing.  No 
matter  how  low  the  rate,  they  will  not  rediscount  so  long  as  their  own 


BUSINESS  FORECASTING 


IOI 


funds  are  lying  idle.  Hence  a  lowering  of  the  rediscount  rate  is  like 
an  importation  of  gold  in  times  when  reserves  are  already  superabun¬ 
dant,  or  an  immigration  of  labor  in  times  when  our  own  labor  forces 
are  largely  unemployed,  or  the  opening  of  new  land  for  settlement  in 
a  pioneer  country  where  there  is  already  good,  free  land.  It  has  no 
immediate,  direct  effect;  it  only  gives  assurance  that  there  are  larger 
resources  to  be  drawn  upon  in  case  of  need. 

The  call-loan  rates  are  of  no  barometric  significance  except  to 
stock-market  speculators,  and  of  very  little  significance  even  to  them.1 
Very  high  call  rates  precede,  and  still  higher  rates  accompany,  a  panic, 
but  there  are  many  extreme  fluctuations  in  call-loan  rates  which  are 
not  the  accompaniment  of  important  changes  in  business,  so  that  con¬ 
clusions  based  on  the  call  rates  necessarily  involve  a  large  margin  of 
error. 

The  rates  of  foreign  exchange  do  not  constitute  a  reliable  business 
barometer ,  but  they  deserve  brief  notice  because  so  many  people 
attempt  to  make  barometric  use  of  them.  Under  normal  conditions, 
the  rates  of  exchange  reflect  changes  in  the  volume  of  payments  to 
be  made  between  countries,  but  these  changes  are  rarely  of  any 
importance  from  the  standpoint  of  the  outlook  for  prosperity  in  this 
country.  During  and  since  the  war,  the  European  exchanges  have  in 
many  cases  been  maintained  by  deliberate  action  of  governments  at 
certain  levels,  and  where  this  is  not  the  case  they  reflect  speculators’ 
estimates  of  the  financial  and  political  prospects  of  European  govern¬ 
ment  rather  than  business  conditions  or  prospects.  This  is  not 
true  of  some  of  the  neutral  countries,  but  in  the  disturbed  condition 
of  European  finances  it  is  quite  hopeless  to  undertake  a  business 
forecast  on  the  basis  of  the  evidence  furnished  by  any  type  of  foreign 
exchange. 

Numerous  indices  may  be  combined  into  a  single  11  composite  barom¬ 
eter .” — There  are  so  many  kinds  of  business  statistics,  and  it  is  so 
.  difficult  to  estimate  the  relative  importance  to  be  attached  to  each  of 
them,  that  it  has  occurred  to  many  students  of  business  conditions 
to  try  to  cut  short  the  task  of  interpretation  by  combining  the  whole 
body  of  data  into  one  or  more  averages.  Their  idea  is  that  if  proper 
weight  is  given  to  each  item  in  constructing  the  average,  the  result 
will  be  a  more  dependable  indication  of  the  general  outlook  than  will 
any  single  item.  Such  averages  are  known  as  composite  barometers. 
Supporters  of  this  method  of  studying  the  business  outlook  point  out 

‘The  point  is  discussed  more  fully  in  chap.  ix. 


102 


RISK  AND  RISK-BEARING 


that  all  use  of  statistics  rests  upon  a  process  of  throwing  together,  into 
a  single  class,  items  which  are  not  exactly  alike,  and  that  making  a 
composite  barometer  in  which,  for  example,  pig-iron  production  is 
combined  with  bank  clearings,  is  only  a  step  further  than  the  combin¬ 
ing  of  different  kinds  of  pig  iron  or  the  clearings  of  different  cities  into 
a  single  item.  In  the  latter  case,  the  items  combined  differ  in  some 
ways  but  are  alike  in  the  characteristics  in  which  we  are  at  the  mo¬ 
ment  interested,  hence,  we  are  justified  in  throwing  them  together; 
if  changes  in  pig-iron  production  and  in  bank  clearings  actually  do 
have  the  same  significance  for  our  problem,  we  are  equally  justified 
in  combining  them.  It  is  of  course  important  that  the  figures  shall 
be  so  handled  that  each  shall  have  its  proper  importance  in  compari¬ 
son  with  the  others,  but  it  is  perhaps  no  more  difficult  to  determine 
their  relative  importance  for  the  purpose  of  making  the  composite 
barometer  than  it  is  to  determine  the  relative  importance  to  be  ascribed 
to  each  item  when  they  are  studied  separately.  The  composite 
barometer  has  the  great  advantage  that  once  the  averaging  is  done 
anyone  can  use  the  results  without  repeating  the  whole  process  of 
weighing  and  comparing  the  data. 

On  the  other  hand,  the  differences  between  items  always  have  some 
significance,  and  the  more  averaging  we  do  the  more  details  of  the  evi¬ 
dence  we  lose.  How  far  it  is  best  to  combine  data  depends  on  the 
amount  of  time  the  users  of  the  reports  are  willing  to  spend  in  com¬ 
paring  items,  and  on  the  relative  importance  attached  to  the  similari¬ 
ties  and  the  differences  in  the  data.  No  one  can  make  anything  out  of 
a  mass  of  raw  statistics  without  some  classification,  while  an  excessive 
amount  of  combination  squanders  part  of  the  evidence. 

In  the  construction  of  all  such  composite  barometers,  two  adjust¬ 
ments  are  necessary.  In  the  first  place,  allowance  must  be  made  for 
“seasonal  fluctuation,”  that  is,  the  change  which  occurs  regularly  at 
the  same  season  of  year.  In  many  cases,  this  allowance  must  also 
be  made  in  interpreting  data  without  the  use  of  composite  indices. 
For  instance,  in  1921,  very  gloomy  predictions  concerning  the  outlook 
for  the  finances  of  the  railways  were  made  in  the  press  on  account  of 
the  falling  off  in  traffic  during  the  winter  months,  disregarding  the 
fact  that  most  of  the  decline  was  to  be  accounted  for  as  a  normal 
seasonal  tendency. 

The  other  correction  which  must  usually  be  made  is  an  allowance 
for  the  normal  increase  in  the  volume  of  business,  which  occurs  from 
year  to  year  with  the  growth  of  the  country.  For  example,  between 


BUSINESS  FORECASTING 


103 


1903  and  1915,  the  production  of  pig  iron  in  this  country  increased 
from  17,000,000  to  20,000,000  tons.  Yet  during  this  interval  there 
were  four  years  when  the  production  was  smaller  than  in  the  preceding 
year.  Clearly  we  have  to  deal  here  with  at  least  two  distinct  types 
of  variation,  the  general  increase  running  on  from  year  to  year,  and 
the  fluctuation  which  accompanies  the  coming  and  going  of  pros¬ 
perity.  The  correction  of  the  statistics  for  this  growth  element  is 
made  by  estimating  the  normal  increase  and  converting  the  actual 
figures  into  deviations  from  this  normal  figure.  In  making  a  com¬ 
posite  index,  the  trend  may  be  removed  from  the  composite  figure,  or, 
better,  removed  from  each  item  separately  before  the  average  is  com¬ 
puted. 

The  earliest  composite  barometers  in  the  United  States  were  com¬ 
piled  by  commercial  organizations  whose  business  was  the  sale  of 

* 

statistics  and  advice  to  business  men  for  their  aid  in  deciding  questions 
of  business  policy  and  especially  investment  questions.  Of  these 
barometers,  the  best  known  and  the  simplest  is  the  Babson  Composit- 
plot,”  published  by  the  Babson  Statistical  Organization  as  one  feature 
of  an  extensive  business,  investment,  and  speculative  service. 

The  “ Babson  Compositplot”  is  based  on  the  theory  that  “ action 
equals  reaction .” — The  “Compositplot”  consists  of  a  line  drawn  on  a 
chart  to  represent  the  average  of  certain  business  items  for  successive 
periods,  beginning  with  1904,  through  which  line  is  drawn  another 
representing  the  normal  growth  of  business  for  the  same  period,  the 
area  between  the  line  of  normal  growth  and  the  line  of  actual  growth 
being  heavily  shaded.  The  interpretation  of  the  “Compositplot” 
is  that  the  formation  of  an  area  above  the  line  of  normal  growth  fore¬ 
casts  the  formation  of  an  area  of  similar  size  below  the  line  of  normal 
growth,  and  vice  versa.  The  construction  of  the  chart  has  been 
described  by  its  inventor,  Mr.  Roger  W.  Babson,  as  follows: 

In  recent  years  there  has  developed  a  school  of  thought  which  bases  its 
prognostications  on  what  is  known  as  the  “area  theory.”  This  area  theory 
considers  both  the  factor  of  time  and  the  factor  of  intensity,  or  prices. 
Their  prognostications  of  prices  are  based  on  the  product  of  these  factors 
of  time  and  prices,  or,  in  other  words,  on  the  area  consumed. 

In  short,  this  new  school  draws  an  oblique  line,  with  a  slope  based  on 
the  normal  increase  in  the  nation’s  volume  of  trade.  Starting  at  a  time 
when  the  business  of  the  country  is  practically  normal,  such  as  early  in 
1903,  actual  business  conditions  are  plotted  from  month  to  month.  This 
gives  certain  areas  below  and  above  this  line  of  normal  growth . 


104 


RISK  AND  RISK-BEARING 


This  Composite  plot,  therefore,  shows  merchants  the  actual  condi¬ 
tions  existing  at  any  given  time  and,  on  the  assumption  that  these  areas 
tend  to  be  equal  in  area,  not  in  shape,  it  aids  them  in  forecasting  future 
conditions  by  showing  whether  the  next  area  may  be  expected  above 
or  below  the  line  of  normal  growth  and  about  how  long  before  it  will 
come . 

A  little  thought  shows  how  reasonable  is  this  theory  and  how  it  auto¬ 
matically  adjusts  itself  to  conditions  the  same  as  a  “governor”  on  an  engine. 
For  instance,  if  prices  increase  twenty-five  per  cent  above  normal,  it  is  not 
reasonable  to  think  that  they  will  continue  to  go  up  until  they  reach  the 
last  previous  high  price  of  one  hundred  per  cent,  irrespective  of  the  time 
consumed,  but  it  is  reasonable  to  suppose  that  after  prices  have  held  this 
increase  of  twenty-five  per  cent  for  a  period  of  four  times  as  long  as  they  had 
when  selling  at  the  previous  high  advance  of  one  hundred  per  cent,  that  the 
time  has  arrived  when  logically  they  should  fall. 

In  other  words,  the  theory  is  that  business  conditions,  as  a  whole,  can 
continue  with  “the  throttle  one-fourth  open”  about  four  times  as  long  as 
with  the  throttle  wide  open;  or,  to  word  it  another  way,  when  conditions 
are  “doubly  prosperous,”  said  prosperity  can  last  only  one-half  the  period 
of  time  that  it  could  if  conditions  were  only  moderately  prosperous.  This 
school  believes  that  if  the  country  would  be  willing  to  run  along  at  a  normal 
rate  of  speed  so  that  the  line  for  actual  business  would  correspond  with  the 
line  of  normal  growth,  we  would  always  have  moderately  prosperous  con¬ 
ditions  with  a  steady,  slow  advance.  On  the  other  hand,  the  higher  the  line 
for  actual  business  rises  above  the  line  of  normal  growth,  the  shorter  length 
of  time  prices  will  remain  high  and  conditions  abnormally  prosperous.1 

The  “  Compositplot ”  is  compiled  in  the  following  way:  The 
actual  figures  for  the  data  which  enter  into  the  plot  are  reduced  to 
“index  figures”  through  the  use  of  technical  methods  which  are  the 
invention  of  the  Babson  Organization.  The  data  are  then  segregated 
into  the  following  groups: 

Mercantile  conditions 

i  Immigration 

2.  New  building 

3.  Failures 

4.  Check  transactions2 

Monetary  conditions 

1.  Commodity  prices 

2.  Total  foreign  trade 

3.  Foreign  money  rates 

4.  Domestic  money  rates 

1  Annals  of  the  American  Academy  of  Political  and  Social  Science,  xxxviii, 
180-83.  (Philadelphia,  1911.) 

2  Check  transactions  substituted  for  bank  clearings  January  i,  1922. 


BUSINESS  FORECASTING 


105 


Investment  conditions 

1.  Yield  of  leading  crops 

2.  Railroad  earnings 

3.  Canadian  conditions 

4.  Stock-market  conditions 

Then  the  figures  in  each  group  are  combined  to  give  an  index  number 
which  reflects  the  activity  of  business  in  general. 

After  the  index  numbers  are  compiled  and  plotted  it  remains  to 
locate  the  X-Y  line,  or  line  of  normal  growth,  in  order  that  the  areas 
above  and  below  the  line  may  be  compared.  In  doing  this,  bank 
clearings  outside  New  York  City  are  used  as  an  indicator,  but  the 
trend  shown  by  the  clearings  is  modified  by  observation  of  the  other 
data.  As  the  compilers  have  stated  it: 

As  it  is  always  dangerous  to  use  one  subject  alone,  especially  a  subject 
reflecting  surface  movements,  it  is  necessary  to  take  bank  clearings  as  an 
indicator  only,  and  to  check  conclusions  based  upon  it,  at  the  end  of  each 
year,  by  all  the  important  barometers  of  wealth  which  report  annually; 
and  again,  at  the  end  of  each  cycle,  by  the  area  of  the  Compositplot. 
In  other  words,  we  endeavor  to  rely  only  on  our  statistics  in  locating  this 
X-Y  line  and  thus  far  we  have  usually  been  able  to  do  this,  but  we  frankly 
assume  that  the  areas  should  be  equal.  Therefore,  this  chart  does  not 
prove  that  the  law  of  action  and  reaction  applies  to  business,  but  rather 
assumes  it. 

The  location  of  this  line  is  fundamentally  based  on  the  assumption  that 
action  and  reaction  are  equal  when  the  total  force  involved  is  considered, 
which  force  may  be  expressed  graphically  by  an  area.  If  this  assumption  is 
correct,  the  sum  of  the  areas  below  the  line  of  normal  growth  must  approxi¬ 
mately  be  equal  to  the  sum  of  the  areas  above  the  line  of  normal  growth; 
and  by  the  law  of  averages  all  of  the  areas  tend  to  be  approximately  equal. 
In  other  words,  if  the  law  of  equal  reaction  is  applicable  in  economics  as  in 
every  other  science,  then  our  line  is  located  with  sufficient  correctness; 
on  the  other  hand,  if  this  law  of  action  and  reaction  does  not  apply  to 
economics,  then  of  course  the  Area  Theory  cannot  be  relied  upon  for  fore¬ 
casting  business  changes  and  these  areas  are  of  use  simply  as  a  general 
bird’s-eye  view  of  conditions.  At  the  end  of  the  last  cycle ,  however ,  no  readjust¬ 
ment  was  necessary  to  make  Areas  “D”  and  “E”  equal.  This  fact  is  a  most 
interesting  testimonial  for  the  Area  Theory. 

It  appears  from  the  foregoing  discussion  that  the  so-called  line 
of  normal  growth  does  not  in  fact  represent  merely  the  normal  growth 
of  the  country,  irrespective  of  temporary  conditions  of  prosperity  and 
depression,  but  is  itself  in  part  an  expression  of  the  prosperous  or 


io6 


RISK  AND  RISK-BEARING 


depressed  state  of  business  at  a  particular  time.  This  throws  some 
doubt  on  the  propriety  of  using  the  X-Y  line  as  a  base  from  which  to 
measure  areas  representing  the  extent  of  prosperity  or  depression. 

A  more  serious  defect  of  the  Babson  chart,  however,  from  the 
standpoint  of  scientific  method,  is  the  lack  of  satisfactory  proof  of 
the  fundamental  principle  of  “ action  equals  reaction.”  It  may  be 
true  that  “the  law  of  action  and  reaction  applies  to  economics  and 
human  relations,  en  masse ,  as  it  applies  to  mechanics.”  The  facts 
available  are  not  conspicuously  inconsistent  with  the  theory.  But 
there  has  been  no  satisfactory  investigation  to  determine  the  weight 
of  evidence  in  favor  of  the  theory,  and  it  cannot  at  present  be  regarded 
as  more  than  an  interesting  hypothesis.  Until  such  research  is  accom¬ 
plished,  students  of  social  science  will  remain  skeptical  of  the  validity 
of  forecasting  methods  which  depend  on  its  detailed  application. 

The  Brookmire  barometers  combine  data  which  have  been  classified 
according  to  the  sequence  of  their  fluctuations . — The  theory  of  forecasting 
upon  wThich  the  methods  followed  by  the  Brookmire  Economic  Sendee 
are  based,  instead  of  combining  all  the  statistical  data  into  a  single 
index,  postulates  a  chronological  sequence  of  business  events,  and 
combines  only  those  which  tend  to  fluctuate  at  the  same  time.  The 
data  for  most  of  the  barometric  indices  constructed  by  this  service 
have  therefore  been  selected  because  movement  in  them  occurs  in 
point  of  time  prior  to  some  price  index  or  other  statistical  factor 
which  it  is  desired  to  forecast,  rather  than  in  an  attempt  to  portray 
the  entire  field  of  business  conditions  in  a  single  picture.  The  Brook¬ 
mire  organization  claims  that  one  great  fundamental  factor  which 
James  H.  Brookmire,  the  founder  of  this  service,  brought  as  a  new 
contribution  to  the  science  of  business  forecasting  was  the  con¬ 
ception  that  changes  in  financial  and  business  conditions  do  not  all 
occur  at  one  time  but  do  occur  in  a  chronological  sequence. 

Both  seasonal  variation  and  secular  trend  are  mathematically 
eliminated  from  the  data  used  in  the  final  presentation  before  they 
enter  into  the  Brookmire  barometric  chart.  Of  the  many  barometric 
charts  which  have  been  constructed  in  seeking  statistical  measures 
which  move  prior  to  many  factors  which  an  economic  service  seeks  to 
forecast  in  its  regular  work,  only  the  two  which  are  now  being  pub¬ 
lished  and  one  important  forerunner  will  be  described. 

“Barometer  No.  i  ”  is  a  chart  which  is  intended  to  forecast  the 
movement  of  industrial  stock  prices  and  of  commodity  prices.  The 
theory  of  the  barometer  is  that  whenever  the  forecasting  line  turns 


BUSINESS  FORECASTING 


.  107 


upward,  industrial  stocks  will  rise  almost  at  once  and  commodity 
prices  about  six  months  later  than  industrial  stock  prices,  with  the 
qualifications  (a)  that  the  change  in  commodity  prices  is  more  accu¬ 
rately  forecast  by  the  turn  of  the  stocks  than  by  the  turn  of  the 
forecasting  line  and  ( b )  that  in  cases  where  the  upward  or  downward 
movement  of  stock  prices  reverses  itself  within  six  months,  the 
corresponding  movement  of  commodity  prices  is  likely  to  be  too  small 
to  be  of  any  practical  importance.  The  forecasting  line  is  a  mathe¬ 
matical  composite  of  the  following  six  factors,  each  given  the  weight 
“which  past  experience  indicates  that  they  really  have”  in  every 
change  of  business  and  investment  conditions: 

1.  A  combination  of  industrial  and  railroad  stock  prices.  These 
are  included  on  the  theory  that  when  stocks  are  selling  at  higher 
than  average  prices  they  are  likely  to  move  downward,  and  vice  versa. 

2.  Physical  volume  of  commodities  coming  into  the  market. 
Eight  measures  of  volume  are  used  to  test  this  factor.  The  theory 
is  that  accumulation  of  excess  stock  is  likely  to  lead  to  liquidation, 
and  shortage  is  likely  to  lead  to  increased  production. 

3.  The  ratio  of  merchandise  imports  to  merchandise  exports. 
Exceptional  imports  are  considered  to  be  equivalent  to  exceptionally 
heavy  volume  of  production. 

4.  Turnover  of  bank  deposits. 

5.  Commercial  paper  rates. 

6.  Interest  rates  in  London. 

“Barometer  No.  2”  is  a  similar  forecasting  line  which  is  intended 
to  forecast  the  movement  of  the  prices  of  bonds  and  of  railroad  stock. 
This  barometer  is  constructed  in  the  same  way  as  Barometer  No.  1 
except  that  commodity  prices  are  introduced  as  a  seventh  factor,  on 
the  theory  that  advancing  prices  of  commodities  are  unfavorable  to 
bonds  and  to  railroad  stocks. 

Notice  should  also  be  taken  of  a  chart  formerly  published  by  the 
Brookmire  Service,  “The  United  States  Barometer  Chart,”  which 
is  important  as  a  forerunner  of  the  chart  now  published  by  the  Harvard 
Economic  Service.  This  chart  contained  three  factors,  which  were 
plotted  separately:  '(1)  the  index  of  banking  funds;  (2)  the  index  of 
security  prices;  (3)  the  index  of  general  business.  It  was  stated  that 
these  three  graphs  moved  in  chronological  order,  the  banking  index 
rising  first,  followed  by  the  stock-market  index,  and  finally  by  the 
business  index.  A  great  rise  in  the  business  index,  in  turn,  produced  a 
fall  in  the  banking  index,  and  this  was  followed  in  turn  by  the  stock- 


RISK  AND  RISK-BEARING 


108  . 

market  index,  and  the  business  index,  and  the  cycle  was  ready  to 
start  again. 

The  banking  index  was  based  upon  (a)  the  total  cash  and  reserves 
of  New  York  clearing-house  banks;  (b)  the  percentage  of  these  reserves 
to  loans;  (c)  the  percentage  of  loans  to  deposits;  ( d )  the  rate  on  first- 
class  commercial  paper  in  New  York  (6,  c,  and  d  reversed  in  sign). 
The  index  of  security  prices  was  an  average  of  prices  of  thirty-two 
leading  stocks.  The  index  of  general  business  was  based  on  bank 
clearings,  railroad  earnings,  pig-iron  production  and  prices,  commodity 
prices,  imports,  building,  and  immigration. 

This  sequence,  it  will  be  noted,  is  practically  that  which  was  indi¬ 
cated  as  typical  in  an  earlier  section  of  this  chapter,  and  has  in  most 
respects  been  verified  by  the  investigations  of  the  Harvard  Committee 
on  Economic  Research.  The  introduction  of  the  Federal  Reserve 
System  and  the  restriction  of  immigration,  however,  have  destroyed 
the  former  relationship  between  certain  of  the  items. 

The  Harvard  11  Index  of  General  Business  Conditions”  represents 
the  most  ambitious  and  painstaking  effort  yet  made  to  establish  a 
relationship  between  the  coming  and  going  of  prosperity  and  the  fluctua¬ 
tions  of  selected  data  which  may  be  used  as  forecasters. — This  index  was 
developed  by  the  Harvard  Committee  on  Economic  Research  and  is 
published  in  the  Review  of  Economic  Statistics  and  in  the  Harvard 
Economic  Service. 

In  brief,  this  investigation  is  an  attempt  to  apply  the  method 
utilized  at  an  earlier  date  by  Brookmire,  of  classifying  the  data  with 
respect  to  the  time  of  their  typical  fluctuations,  putting  into  one  group 
those  items  which  tend  to  move  ahead  of  changes  in  the  volume  of 
general  business,  into  a  second  those  which  serve  as  thermometers 
reporting  the  activity  of  business  at  a  given  time,  and  into  a  third 
those  which  generally  lag  behind;  then  combining  those  which  move 
together  into  a  composite  index  so  that  the  effect  of  accidental  varia¬ 
tion  in  one  item  may  be  reduced  or  eliminated.  The  movement  of  one 
index  is  regarded  as  a  forecaster  of  the  next.  A  more  minute  classi¬ 
fication  into  five  groups  has  also  been  made,  though  the  three-group 
classification  has  so  far  appeared  to  be  most  useful. 

The  principal  differences  between  this  investigation  and  those 
which  have  preceded  it,  particularly  Brookmire’s,  are  first,  the  much 
more  elaborate  and  scientific  methods  used  to  get  rid  of  the  seasonal 
fluctuations  and  the  secular  trend,  and  second,  the  classification  of  the 


BUSINESS  FORECASTING 


109 


data  into  groups  according  to  the  results  of  a  very  minute  study  of  the 
order  in  which  they  have  preceded  one  another  in  the  past. 

Every  effort  has  been  made  to  treat  the  statistical  data  in  an  imper¬ 
sonal  way  so  that  the  element  of  personal  judgment  may  be  reduced 
to  the  minimum  and  the  results  may  be  the  same  that  any  scholar 
would  get  from  the  same  data.  The  question  whether  one  item 
typically  precedes  another  in  its  rise  and  fall  has  been  determined, 
not  by  analysis  of  the  cause  and  effect  relation  between  them,  but  by 
figuring  mathematically  the  degree  of  correspondence  between  their 
fluctuations  when  they  are  compared  as  they  occurred,  then  moving 
the  record  of  one  of  them  two,  four,  six,  or  more  months  ahead  of  the 
other  and  calculating  the  degree  of  correspondence  again.  The  degree 
of  correspondence  is  figured  by  the  use  of  the  “coefficient  of  correla¬ 
tion,”  a  device  widely  used  in  biological  studies  and  introduced  into 
social  and  business  studies  within  the  last  fifteen  years,  chiefly  by 
English  statisticians. 

The  validity  of  these  mathematical  methods  of  treating  statistical 
data  depends  on  the  utilization  of  statistics  covering  quite  a  large 
number  of  cases,  hence  the  choice  of  data  is  limited  to  those  items  for 
which  comparable  data  are  available  over  a  long  period.  For  com¬ 
parison  involving  annual  data,  only  those  items  have  been  used  which 
could  be  traced  back  in  comparable  form  to  1879,  while  monthly 
data  running  back  to  1903  have  been  considered  sufficient.  Seventeen 
series  of  annual  data  for  the  years  1879-1913  and  twenty-three  series 
of  monthly  data  for  the  years  1903-16  or  for  longer  periods  were 
included.  The  twenty- three  series  are  as  follows: 

1.  Bank  clearings  of  New  York  City 

2.  Tonnage  of  pig  iron  produced  in  United  States 

3.  Bank  clearings  outside  of  New  York  City 

4.  Bradstreet’s  index  of  commodity  prices 

5.  Imports  of  merchandise  into  United  States,  values 

6.  Values  of  building  permits  issued  for  twenty  leading  cities 

7.  Gross  earnings  of  ten  leading  railroads 

8.  Number  of  shares  sold  on  the  New  York  Stock  Exchange 

9.  Unfilled  orders  of  United  States  Steel  Corporation 

10.  Tonnage,  less  lake  traffic,  of  vessels  entered  in  the  foreign  commerce 
of  the  United  States 

11.  Bradstreet’s  number  of  business  failures 


no 


RISK  AND  RISK-BEARING 


12.  Rate  of  interest  on  ten  American  railroad  bonds 

13.  Rate  of  interest  on  four  to  six  months’  commercial  paper 

14.  Rate  of  interest  on  sixty-  to  ninety-day  commercial  paper  in  New  York 

15.  Rate  of  interest  on  call  loans  at  the  New  York  Stock  Exchange 

16.  Bureau  of  Labor  Statistics’  prices 

17.  Dividend  payments 

18.  Prices  of  industrial  stocks 

19.  Prices  of  railroad  stocks 

20.  Incorporations  in  eastern  states 

21.  Loans  of  New  York  banks 

22.  Reserves  of  New  York  banks 

23.  Deposits  of  New  York  banks 

The  first  step  in  the  analysis  was  the  isolation  of  the  various  types 
of  fluctuation  which  are  found  in  the  data.  As  a  working  hypothesis, 
these  were  considered  as  fourfold:  (1)  A  long-time  tendency  to 
increase  or  decrease,  which  in  technical  language  is  termed  the  secular 
trend;  (2)  a  cyclical  movement  superimposed  upon  the  first,  the 
extremes  being  found  in  periods  of  prosperity  and  depression;  (3)  a 
seasonal  movement  within  the  year;  and  (4)  irregular  variations.  The 
four  types  of  fluctuation  are  however  not  uniform  in  the  different 
series,  and  in  consequence  individual  treatment  of  each  series  was 
required.  It  became  necessary  first  to  measure  the  secular  trend. 
This  was  accomplished  by  “fitting”  a  straight  line  or  other  curve  to 
tjie  graph  representing  the  original  series.  For  example,  in  treating 
bank  clearings,  a  dot  was  placed  on  a  chart  so  that  its  distance  from 
the  base  indicated  the  volume  of  clearings  in  a  given  year,  the  years 
being  measured  off  in  equal  spaces  from  the  left  side  of  the  chart. 
It  is  obvious  that  if  the  increase  in  clearings  were  exactly  the  same 
in  each  successive  year  the  dots  would  all  lie  on  the  same  straight 
line,  and  the  slope  of  this  line  would  indicate  the  rapidity  of  the 
increase  in  bank  clearings.  The  method  of  “curve  fitting”  consists 
in  drawing  a  line  so  that  it  comes  as  near  as  possible  to  passing  through 
all  the  dots.  This  can  be  done  with  great  accuracy  by  the  use  of 
mathematical  formulas.  The  slope  of  the  fitted  line  is  considered  to 
measure  the  secular  trend  or  normal  growth,  and  the  deviation  of  the 
dots  from  the  line  to  measure  the  fluctuation  not  due  to  growth.  The 
assumption  is  that  a  rate  of  growth,  shown  by  examining  data  of  a 
number  of  years  in  the  past,  will  continue  to  be  the  rate  of  normal 
growth  in  the  future,  so  the  line  is  carried  forward  with  a  uniform 


BUSINESS  FORECASTING 


in 


slope.  It  is  recognized  however  that  this  trend  can  really  be  deter¬ 
mined  only  for  the  past  period,  and  in  certain  cases  may  by  no  means 
afford  a  good  basis  for  estimating  future  trend. 

The  determination  of  normal  seasonal  variation  in  the  data  was 
next  undertaken.  The  method  used  is  very  involved  and  may  con¬ 
veniently  be  divided  into  the  following  steps:  (i)  Relative  figures 
are  first  calculated  expressing  the  absolute  figure  for  each  month  as  a 
percentage  of  the  absolute  figure  for  the  previous  month;  (2)  medians 
of  the  month-to-month  percentages  are  then  calculated  for  each  of  the 
twelve  months.  The  median  is  the  item  midway  of  the  series.  Thus 
it  was  found  that  in  twenty-four  years  the  business  failures  reported  by 
Bradstreet’s  for  April  ranged  from  77  per  cent  to  117  per  cent  of  the 
figures  for  March  of  the  same  year,  but  that  in  half  the  years  the  per¬ 
centage  was  less  than  96  and  in  half  more  than  that  figure.  Ninety- 
six  per  cent  is  therefore  considered  the  typical  ratio  of  failures  for 
April  to  those  for  March,  though  it  appears  that  in  no  year  was  the 
percentage  exactly  96;  (3)  the  medians  are  expressed  as  a  continuous 
series  using  January  as  base;  (4)  they  are  then  adjusted  so  that  the 
discrepancy  between  consecutive  January  relatives  (due  to  the  secular 
trend)  is  o;  (5)  they  are  changed  to  a  new  base  by  dividing  each  item 
in  the  fourth  series  by  the  arithmetic  average  of  that  series.  These 
adjustments  are  technically  necessary  in  order  to  get  the  results  into 
a  form  to  use  them  as  corrective  factors. 

The  series  of  items  is  modified  by  this  seasonal  corrective  factor, 
and  the  resulting  series  gives  the  data  with  the  influence  of  both  secular 
trend  and  seasonal  fluctuation  eliminated.  This  is  done  as  follows: 
Each  of  the  “monthly  ordinates  of  the  secular  trend”  is  multiplied 
by  the  index  of  seasonal  variation  for  that  month,  obtained  in  the 
manner  stated  above.  ,  In  other  words,  the  line  which  depicts  the 
normal  growth. of  the  item  from  year  to  year  is  modified  so  as  to  repre¬ 
sent  the  normal  growth  plus  or  minus,  the  normal  seasonal  fluctuation. 
The  normal  monthly  figures  obtained  in  this  way  are  then  subtracted 
from  the  actual  figures  and  the  result  is  a  series  of  figures  representing 
the  deviation  of  the  movement  of  the  item,  bank  clearings,  for  instance, 
from  what  it  would  be  if  it  were  affected  only  by  seasonal  factors  and 
the  growth  of  business. 

This  series  of  deviations  comprises  the  fluctuation  due  to  the  busi¬ 
ness  cycle  and  also  the  irregular  fluctuation  caused  by  conditions 
special  to  the  particular  business  from  which  the  data  are  drawn. 
No  attempt  is  made  to  separate  the  irregular  from  the  cyclical  factor, 


1 12 


RISK  AND  RISK-BEARING 


but  it  is  assumed  in  combining  the  data  into  a  composite  index  the 
irregular  changes  in  each  separate  series  will  tend  to  disappear  and  the 
general  average  will  reflect  the  effect  of  conditions  common  to  all 
lines  of  business,  that  is,  of  the  coming  and  going  of  prosperity  and 
depression. 

Before  the  comparisons  can  be  made,  one  other  correction  is 
necessary.  Some  of  the  series  fluctuate  widely,  for  instance,  pig-iron 
production  and  call-loan  rates.  Others  have  a  very  narrow  range  of 
fluctuation,  for  instance,  the  yield  on  railroad  bonds.  Each  series 
is  therefore  divided  throughout  by  a  figure  representing  its  own  aver¬ 
age  deviation  from  its  own  average.  This  makes  the  average  fluctua¬ 
tions  equal  and  facilitates  comparison  of  the  time  of  the  fluctuations, 
which  is  the  only  thing  we  are  interested  in. 

For  technical  reasons  the  standard  deviation,  which  is  the  square 
root  of  the  sum  of  the  squares  of  the  deviations  divided  by  their 
number,  is  used  rather  than  their  simple  average. 

It  was  found  that  the  series  fall  into  three  quite  distinct  groups 
when  arranged  in  the  order  of  their  fluctuation.  There  were  variations 
within  the  groups,  particularly  the  middle  one,  but  the  degree  of  corre¬ 
spondence  in  each  group  was  much  greater  than  the  difference  between 
the  groups  so  that  the  classification  was  unmistakable.  The  series 
which  fluctuate  first,  either  upward  or  downward,  are  all  series  depend¬ 
ing  upon  investment  and  speculation,  such  as  the  average  price  of  ten 
railroad  bonds,  the  average  price  of  industrial  and  of  railroad  stocks, 
the  volume  of  sales  on  the  New  York  Stock  Exchange,  and  New 
York  clearings.  This  is  the  speculative  group. 

The  series  in  which  the  fluctuations  follow  or  lag  behind  the 
fluctuation  of  the  speculative  group  all  have  to  do  with  business  and 
industrial  activity,  such  as  pig-iron  production,  bank  clearings  outside 
of  New  York  City,  and  wholesale  prices. 

The  third  group,  in  which  the  items  lag  behind  the  business  group 
in  their  rise  or  fall,  are  items  having  to  do  with  the  banking  business. 
They  consist  of  interest  rates,  variously  classified,  bank  reserves, 
loans,  and  deposits. 

The  final  step  in  the  preparation  of  the  general  index  is  to  construct 
a  curve  portraying  the  combined  data  for  each  of  the  three  groups  of 
data.  Curve  A,  representing  the  speculative  group,  forecasts  by  its 
rise  or  fall,  a  rise  or  fall  in  curve  B,  the  business  group;  curve  B  like¬ 
wise  by  its  changes  forecasts  corresponding  changes  in  curve  C,  the 
money  group;  curve  C  by  its  changes  forecasts  opposite  changes  in 
curve  A. 


BUSINESS  FORECASTING 


113 

It  will  be  noticed  that  in  the  final  classification  and  utilization  of 
the  data,  this  system  bears  a  striking  resemblance  to  the  Brookmire 
method  which  was  described  on  page  106.  The  Brookmire  system 
was  based  apparently  on  observations  and  economic  analysis;  the 
Harvard  system  based  on  minute  impersonal  statistical  analysis  gives 
a  striking  confirmation  of  its  most  important  conclusions. 

The  question  next  arises,  what  is  the  degree  of  success  in  forecasting 
by  means  of  this  system?  For  the  period  from  1903  to  1914,  the 
curves  show  striking  regularity.  Both  in  the  depressions  of  1904, 
1908,  and  1911,  and  in  the  prosperity  periods  of  1905-6,  1909-10, 
and  1912,  the  curves  turn  up  and  down  in  invariable  order  and  with  a 
high  degree  of  regularity  in  the  time  interval  between  them.  This 
was  only  to  be  expected,  however,  as  the  indices  were  made  chiefly 
on  the  basis  of  the  actual  course  of  events  during  this  period.  For 
the  period  from  1914  to  1918,  the  index  proved  to  be  valueless.  The 
fluctuations  of  the  data  were  determined  by  the  exigencies  of  war  prod¬ 
uction  and  war  finance  to  such  an  extent  that  the  normal  relationships 
of  the  business  cycle  were  entirely  obscured.  No  conclusion  as  to 
the  value  of  the  barometer  could  be  drawn  from  such  an  abnormal 
period. 

For  the  years  from  1919  through  1921,  the  charts  ran  quite  true 
to  form,  thereby  meeting  their  first  real  test.  Curve  A  reached  a 
maximum  in  October  of  1919,  curve  B  in  February  of  1920,  curve  C 
in  July  of  1920  and  February  of  1921.  Curve  A  reached  a  minimum 
in  July  and  October,  1921,  curve  B  in  May,  1921,  and  January,  1922, 
curve  C  apparently  in  September,  1922. 

In  conclusion,  it  may  be  said  that  the  confidence  to  be  placed  in 
such  a  mechanical  forecaster  is  a  question  which  as  yet  cannot  be 
answered,  except  from  the  standpoint  of  theory;  there  is  not  evidence 
enough  to  prove  or  disprove  its  pretensions.  It  should  be  added, 
however,  that  the  publishers  of  the  Harvard  Index  do  not  claim  for 
it  infallibility.  They  point  out  that  such  factors  as  the  establish¬ 
ment  of  the  Federal  Reserve  System,  the  destruction  of  capital 
during  the  war,  and  the  change  of  the  United  States  from  a  debtor  to 
a  creditor  nation  make  it  impossible  to  rely  implicitly  on  forecasts 
based  on  the  compilation  of  precedents  and  make  it  necessary  to 
supplement  the  forecaster  with  the  results  of  economic  analysis. 
A  similar  attitude  is  taken  by  the  publishers  of  the  Babson  and  Brook¬ 
mire  charts.  The  charts  are  furnished  in  each  of  these  three  cases 
as  one  feature  of  an  extensive  service,  other  features  of  which  include 
discussion  of  the  extent  to  which  special  considerations  necessitate 


RISK  AND  RISK-BEARING 


1 14 

modifying  the  conclusions  which  might  be  drawn  from  the  sequence 
of  events  in  the  past. 

NOTE 

SOURCES  OF  BAROMETRIC  DATA 

The  essential  barometric  data  are  easily  obtainable. — The  available 
sources  of  barometric  data  fell  into  three  general  classes:  first,  the  publica¬ 
tions  of  government  bureaus  and  of  banks  and  other  business  institutions, 
which  are  available  gratis  or  at  nominal  cost;  second,  the  periodicals  which 
deal  with  financial  and  business  conditions;  third,  the  special  “business 
services.” 

Of  the  first  class,  there  is  a  considerable  number,  of  which  the  following 
are  among  the  most  valuable:  the  Monthly  Review  of  Credit  and  Business 
Conditions  by  the  Federal  Reserve  Agent  of  the  Federal  Reserve  Bank  of 
New  York,  the  Federal  Reserve  Bulletin ,  the  Survey  of  Current  Business , 
published  by  the  Department  of  Commerce,  the  Monthly  Bulletin  published 
by  the  National  City  Bank  of  New  York. 

Of  the  periodicals,  the  weeklies  are  by  far  the  most  valuable  for  fore¬ 
casting  purposes.  The  following  are  worthy  of  special  mention:  the  Com¬ 
mercial  and  Financial  Chronicle,  the  New  York  Times  Annalist,  Commerce 
and  Finance,  the  Economic  World,  Bradstreets,  Dun’s  Review,  the  Saturday 
edition  of  the  New  York  Evening  Post,  the  Chicago  Economist.  All  these 
publish  weekly  summaries  of  most  of  the  important  data;  a  very  brief 
comparison  is  sufficient  to  indicate  which  of  them  furnish  the  items  in  which 
one  is  particularly  interested. 

For  those  who  wish  more  complete  and  earlier  information  as  to  the 
trend  of  business  conditions  and  are  willing  to  pay  for  having  the  data 
interpreted  as  well  as  collected,  a  number  of  special  business  services  are 
available.  The  Harvard  Economic  Service,  the  service  sold  by  the  Babson 
Statistical  Organization,  and  the  Brookmire  Service  have  already  been 
mentioned  in  connection  with  the  subject  of  composite  barometers.  In 
addition  to  the  barometers  described,  each  of  these  services  furnishes  bulletins 
dealing  with  current  developments  and  offers  interpretations  and  forecasts. 

The  Babson  Service  consists  of  a  General  Barometric  Bulletin,  contain¬ 
ing  the  “  Compositplot  ”  with  brief  comments  and  a  few  notes  on  important 
developments  affecting  business  in  general;  a  Buyers’  Bulletin,  on  commodi¬ 
ties  and  prices;  an  Industries  Bulletin,  forecasting  conditions  in  specific 
industries;  a  Sellers'  Bulletin,  which  deals  with  business  and  credit  condi¬ 
tions  in  specific  localities  all  over  the  country;  a  special  Labor  Bulletin;  and  a 
Bulletin  dealing  with  speculative  securities  and  investments.  The  organiza¬ 
tion  maintains  a  large  statistical  force,  and  furnishes  a  large  amount  of 
information  concerning  the  general  situation  and  also  the  specific  details 
needed  in  modifying  general  conclusions  to  determine  their  application  to 
the  problems  of  the  individual  business.  The  Babson  forecasts  are  very 
definite  and  specific. 

The  Brookmire  Service  furnishes  an  Investment  Opportunities  Bulletin , 
a  Speculative  Bulletin,  a  Building  Bulletin,  a  Sales  and  Credit  Map,  a  Trade 


BUSINESS  FORECASTING 


TIS 

Bulletin ,  and  a  Financial  Bulletin.  These  bulletins  cover  somewhat  the  same 
general  field  as  is  covered  by  the  Babson  Bulletins,  though  as  the  titles  indi¬ 
cate  there  are  some  differences  of  emphasis.  Like  the  Babson  Service,  the 
Brookmire  Service  makes  very  definite  and  intelligible  recommendations 
concerning  the  specific  securities  to  be  bought  and  business  opportunities 
to  be  cultivated  or  avoided. 

The  Harvard  Service  is  relatively  new,  and  represents  the  first  effort 
on  the  part  of  an  educational  institution  to  enter  the  field  of  professional 
business  advice.  The  principal  features  of  the  service  are  a  weekly  letter 
and  monthly  desk  sheet,  which  include  data  of  current  barometric  interest, 
both  the  actual  figures  and  the  items  adjusted  for  seasonal  and  secular 
variation;  the  barometric  curves  discussed  above  and  discussion  of  their 
significance;  special  articles  dealing  with  current  developments  of  impor¬ 
tance,  such  as  foreign  financial  conditions,  tendencies  in  trade,  etc.;  other 
articles  which  present  the  result  of  special  investigations,  such  as  the  tend¬ 
encies  of  a  particular  industry  during  business  depressions;  and  a  quarterly 
publication,  the  Review  of  Economic  Statistics,  which  contains  more  extended 
articles  dealing  with  the  theory  and  history  of  business  cycles  and  kindred 
topics.  The  material  published  in  connection  with  this  service  represents 
a  very  high  standard  of  scholarship  and  has  already  included  numerous 
valuable  additions  to  our  stock  of  knowledge  of  the  phenomena  of  pros¬ 
perity  and  depression.  There  is  no  attempt  to  recommend  specific  invest¬ 
ments  or  details  of  business  policy. 

QUESTIONS 

1.  Show  how  the  justification  of  the  use  of  the  sampling  method  in  studying 
barometric  data  involves  application  of  the  law  of  large  numbers. 

2.  “The  changes  wrought  by  the  war  make  it  necessary  to  supplement  sta¬ 
tistical  comparisons  with  the  results  of  economic  analysis.” 

3.  “Price  changes  may  be  said  to  forecast  their  own  movements.”  Explain. 

4.  Compare  the  significance  of  railway  gross  earnings  and  of  car  loadings, 
as  barometers  of  the  volume  of  trade. 

5.  Under  what  conditions  might  the  management  of  an  industrial  corpora¬ 
tion  have  an  interest  in  coloring  the  reports  of  the  corporation  to  make  it 
appear  more  prosperous  ?  less  prosperous  ? 

6.  Does  the  fact  that  staple  agricultural  products  are  sold  in  a  world-wide 
market  affect  the  barometric  significance  of  the  volume  of  production 
in  this  country  ? 

7.  Why  do  cotton  prices  show  more  tendency  than  do  wheat  prices  to  rise 
greatly  in  years  of  small  production  in  this  country  ? 

8.  Under  what  conditions  may  a  heavy  importation  of  gold  result  in  an 
easing  of  credit  in  this  country  ? 

9.  “Rising  interest  rates  forecast  falling  bond  prices.”  Why? 


CHAPTER  VII 

RISK  AND  THE  MANAGEMENT  OF  CAPITAL 

In  no  other  field  of  business  management  does  the  factor  of  uncer¬ 
tainty  absorb  so  much  attention  as  in  the  investment1  of  capital.  It 
is  true  that  the  control  of  production,  the  administration  of  labor 
relations,  and  the  determination  of  market  policies  constantly  involve 
the  making  of  decisions  on  the  basis  of  evidence  which  is  not  sufficient 
to  establish  the  truth  with  scientific  certainty,  but  they  also  involve 
to  a  large  and  increasing  extent  the  application  of  scientific  methods 
in  the  elimination  of  risk.  In  the  investment  of  capital,  on  the  other 
hand,  it  is  nearly  always  the  case  that  the  final  decision  rests  on  proba¬ 
bility  rather  than  on  knowledge.  The  exceptional  case  is  the  case 
where  the  investor  is  interested  only  in  securing  absolute  safety,  and 
disregards  considerations  of  yield,  but  this  situation  is  very  rare. 
Ordinarily  the  investor’s  objective  is  to  get  something  more  than  the 
yield  which  can  be  had  on  absolutely  safe  investments,  and  his  choice, 
therefore,  rests  upon  a  balancing  of  the  prospective  profits  against  the 
degree  of  risk.  In  this  chapter,  an  attempt  will  be  made  to  compare 
the  various  methods  of  securing  a  return  on  capital  with  reference  to 
the  amount  and  kind  of  risk  involved  in  each. 

Opportunities  for  securing  a  return  for  the  use  of  one’s  capital 
fall  into  the  following  general  classes: 

1.  Investment  directly  in  one’s  own  personally-directed  business. 

a)  Investment  in  new  enterprise. 

b)  Investment  in  extension  of  the  range  or  volume  of  business. 

c )  Investment  to  reduce  the  costs  or  risks  of  business  to  which 
one  is  already  committed. 

2.  Repayment  of  one’s  own  indebtedness  (to  curtail  outgo  for 
interest). 

3.  Deposit  of  money  with  banks,  savings  institutions,  building 
and  loan  associations,  purchase  of  insurance,  etc. 

4.  Purchase  of  securities  with  a  view  to  obtaining  income  from 
interest  or  dividends. 

1  Except  as  otherwise  noted  the  term  “investment”  is  used  in  its  original  broad 
sense  to  designate  all  methods  of  putting  money  into  enterprise,  without  the 
usual  implication  of  safety. 

u6 


RISK  AND  THE  MANAGEMENT  OF  CAPITAL 


117 


5.  Personal  loans,  made  for  the  sake  of  interest. 

6.  Purchase  or  sale  of  securities,  land,  contracts,  or  commodities, 
with  a  view  to  profit  from  price  changes. 

7.  Gambling  transactions. 

Let  us  examine  these  types  of  “investment”  with  a  view  to  deter¬ 
mining  the  relative  degrees  of  risk  which  they  involve. 

1.  The  investment  of  money  in  one’s  own  business  affords  illustra¬ 
tions  of  all  possible  degrees  of  risk. — Investments  to  start  new  businesses 
are  nearly  always  speculative.  The  very  fact  that  an  opportunity 
has  not  been  developed  already  usually  means  that  its  results  are 
uncertain.  As  businesses  grow  older  they  become  less  speculative, 
more  and  more  of  their  problems  having  been  solved.  Nevertheless, 
numerous  risks  assail  nearly  every  type  of  enterprise,  and  it  is  not  at 
all  certain  that  business  as  a  whole  any  more  than  pays  its  own 
interest  and  wages.  Statistics  of  failures  are  available  in  the  United 
States  only  for  commercial,  not  for  industrial,  agricultural,  or  public- 
service  institutions;  these  statistics  indicate  that  the  proportion  of 
failures  runs  from  one-third  of  1  per  cent  in  good  years  to  nearly  2 
per  cent  in  bad  years.  These  figures,  however,  embrace  only  failures 
which  cause  loss  to  creditors;  if  we  had  data  showing  the  number  of 
businesses  which  fail  to  earn  fair  interest  on  their  capital  and  wages  for 
their  owners  the  figures  would  doubtless  run  vastly  higher. 

The  investment  of  capital  in  one’s  own  business  may  offer  an  oppor¬ 
tunity  for  investment  which  is  virtually  free  from  risk,  when  its  effect 
is  to  provide  safeguard  against  risks  already  incurred.  For  instance, 
when  $20,000  has  once  been  invested  in  the  equipment  of  a  plant, 
$2,500  invested  in  an  additional  machine  may  return  much  more  than 
normal  interest  through  the  addition  it  makes  to  the  efficiency  of  the 
plant,  and  the  risk  may  actually  be  decreased  by  the  new  investment. 
After  the  new  investment  $22,500  is  at  risk  instead  of  $20,000  but  the 
probability  of  total  failure  in  the  next  season  of  poor  business  has  been 
reduced  by  the  increased  plant  efficiency,  let  us  say  from  8  chances  in 
a  thousand  to  6  in  a  thousand.  Whereas  the  risk  before  was  mathe¬ 
matically  equivalent  to  a  cost  of  $160  per  year,  it  now  amounts  to 
$135.00.  The  burden  of  the  risk  of  total  failure  has  been  lessened  by 
$25.00  a  year,  quite  apart  from  the  added  income  which  will  result 
from  the  decreased  cost  of  operation  in  years  of  prosperity. 

2.  The  safest  investment  is  the  repayment  of  one’s  own  debts. — When 
a  debtor  pays  off  his  interest-bearing  obligations  he  makes  an  invest¬ 
ment  on  which  the  return  is  the  amount  of  interest  saved.  He  incurs 


1 1 8 


RISK  AND  RISK-BEARING 


absolutely  no  risk  of  losing  his  investment  (unless  the  chance  that  he 
might  otherwise  evade  payment  be  counted  as  creating  a  risk  in 
repayment),  nor  does  he  run  any  risk  of  having  his  investment  return 
to  him  and  lie  idle  on  his  hands.  Moreover,  he  pays  no  taxes  on  the 
investment  (unless  he  was  previously  getting  a  deduction  from  his 
taxes  on  account  of  the  debt).  An  absolutely  safe,  permanent,  and 
tax-free  investment  of  other  types  would  net  him  from  3  to  5  per  cent; 
this  one  will  net  him  6  or  8  per  cent.  The  reason  for  this  discrepancy 
is  that  the  creditor’s  charge  for  the  loan  includes  a  compensation  for 
his  uncertainty  as  to  whether  he  will  be  able  to  collect  his  principal; 
he  figures  his  claim  as  a  more  or  less  risky  asset,  while  the  debtor 
figures  his  liability  as  absolute.  Thus  the  repayment  of  the  debts 
relieves  the  creditor  of  a  risk  without  creating  a  corresponding  risk 
for  the  debtor.  From  the  standpoint  of  risk,  there  is  therefore  a  real 
social  gain  in  the  liquidation  of  debts.  This  may,  of  course,  be  more 
than  offset  by  a  loss  in  productivity,  if  the  capital  could  produce  more 
in  the  hands  of  the  debtor  than  in  the  hands  of  the  owner. 

3.  Deposits  with  financial  institutions  are  usually  very  safe. — 
Deposits  of  funds  with  banks,  investments  through  building  and  loan 
associations  and  investment  trusts,  and  the  purchase  of  investment 
insurance  and  of  annuities,  if  the  institutions  are  honestly  managed, 
offer  an  almost  perfect  assurance  of  safety,  largely  because  their 
success  depends  on  the  success  of  a  great  number  and  variety  of 
enterprises,  some  of  which  will  almost  certainly  fail  but  the  great 
majority  of  which  will  not,  unless  as  the  result  of  a  collapse  of  the 
present  organization  of  industry.  An  equivalent  diversification  of 
investments  would,  of  course,  obtain  the  same  safety  for  the  indi¬ 
vidual  investor  if  he  were  able  to  secure  it,  but  the  financial  institutions 
under  consideration  have  the  advantage  in  their  ability  to  pool  the 
resources  of  a  large  number  of  small  investors  and  spread  them  over  a 
much  larger  number  of  different  investments  than  the  average  investor 
could  include  in  his  list. 

Moreover,  such  institutions  are  usually  conservative  in  their 
choice  of  investments,  and  frequently  are  restricted  closely  by  law  in 
their  selection.  This  is  true  especially  of  savings  banks,  which  as  a 
result  are  able  to  secure  only  a  low  return  on  their  investments,  but 
run  very  little  risk.  Some  advantage  is  gained  also  by  the  specializa¬ 
tion  of  savings  bank  officers  in  judging  the  quality  of  investments. 
The  chief  advantage,  nevertheless,  is  in  the  better  diversification  which 
is  gained  through  the  pooling  of  individual  resources.  Individuals 


RISK  AND  THE  MANAGEMENT  OF  CAPITAL 


lT9 


whose  income  is  large  enough  so  that  they  can  secure  diversification 
in  their  investments  seldom  find  it  advantageous  to  use  the  savings 
bank. 

4.  Investment  in  securities  makes  possible  minute  specialization  in 
risk-bearing. — Incorporation  is  a  device  for  making  possible,  among 
other  things,  a  more  minute  specialization  in  risk-bearing  than  is  pos¬ 
sible  under  the  “  single  entrepreneur  ”  system.  The  issuance  of  various 
types  of  securities  makes  it  possible  for  the  risk  to  be  divided  among 
a  large  number  of  specialists,  each  of  whom  takes  only  a  small  share  in 
the  risk  of  any  particular  business,  and  moreover  takes  in  each  business 
pretty  much  the  kind  of  risk  he  chooses,  some  capitalists  preferring 
to  take  preferred  stocks  or  bonds  offering  a  high  degree  of  safety  with 
comparatively  low  return,  while  others  take  common  stocks  which 
offer  the  possibility  of  larger  return  but  a  larger  degree  of  risk.  By 
varying  the  proportion  of  stocks  and  bonds  and  by  special  contract 
provisions,  the  risk  can  be  divided  in  almost  as  many  ways  as  there 
are  investors. 

At  the  same  time  incorporation,  by  bringing  in  the  principle  of 
limited  liability,  cuts  the  bond  between  control  and  the  bearing  of 
risk,  and  makes  it  possible  for  the  individual  to  invest  his  capital  in 
lines  of  business  concerning  whose  management  he  knows  nothing, 
and  in  which  he  would  never  invest  his  capital  if  it  were  necessary 
for  him  to  learn.  This  makes  possible,  of  course,  a  much  wider 
spreading  of  investments  and  a  corresponding  reduction  of  the  indi¬ 
vidual’s  risk  of  loss.  This  whole  subject  is  well  discussed  by  Pigou:1 

So  long  as  liability  was  unlimited,  it  was  often  against  a  man’s  interest 
to  spread  his  investments;  for,  if  he  did  so,  he  multiplied  the  points  from 
which  an  unlimited  call  on  his  resources  might  be  made.  The  English  Limited 
Liability  Act  of  1862  and  its  foreign  counterparts  enabled  investments  to 
be  spread,  without  evoking  this  danger.  Now,  the  spreading  of  invest¬ 
ments  obviously  means  a  combination  of  uncertainties  on  the  part  of  all 
investors  who  hold  shares  in  more  than  one  company.  But  spreading,  on 
the  basis  of  limited  liability,  carries  with  it  yet  another  element  of  com¬ 
bination.  For,  in  general,  each  business  deals  directly  or  indirectly  with 
many  businesses.  If  one  of  them  fails  for  a  million  pounds,  under  unlimited 
liability  the  whole  of  the  loss  falls  on  the  shareholders  or  partners;  but 
under  limited  liability  a  part  of  it  is  scattered  among  the  shareholders  or 
partners  of  a  great  number  of  businesses.  Hence,  any  shareholder  in  one 
business  combines  with  the  uncertainty  proper  to  his  own  business  some  of 
that  proper  to  other  businesses  also.  It  follows  that  the  range  of  uncer- 

1  Wealth  and  Welfare ,  p.  101. 


120 


RISK  AND  RISK-BEARING 


tainty,  to  which  a  normal  ioo  pounds  invested  in  industry  is  subjected  by 
reason  of  failures,  is  still  further  diminished  in  amount. 

High-grade  bonds  of  industrial  ana  public-utility  enterprises  offer 
a  high  degree  of  safety,  chiefly  because  of  the  large  margin  which 
usually  exists  between  the  income  required  to  meet  charges  on  them 
and  the  normal  income  of  the  businesses,  secondarily  because  they 
are  usually  secured  by  direct  claims  on  assets  of  ample  value.  Here 
it  will  be  noted  that  the  risk  against  which  the  investor  is  protected  is 
that  of  a  partial  failure  of  the  business.  If  there  is  a  complete  col¬ 
lapse  the  charges  cannot  be  met,  unless  out  of  accumulated  earnings 
of  the  past,  and  ordinarily  the  assets  pledged  lose  much  of  their  value. 
All  forms  of  security  depend  ultimately  on  earning  power,  and  are 
subject  to  the  hazards  of  the  business  in  greater  or  less  degree.  But 
when  the  interest  on  a  bond  requires,  say  25  per  cent  of  the  anticipated 
earnings,  a  shrinkage  of  80  per  cent  in  net  means  only  a  20  per  cent 
shrinkage  in  the  amount  available  for  interest,  while  a  60  per  cent 
shrinkage  leaves  enough  to  pay  the  bondholder  his  interest  in  full. 
A  complete  failure  wipes  out  the  bondholder  just  as  it  does  the  stock¬ 
holder,  unless  the  investment  can  be  extricated  and  the  assets  applied 
to  some  other  use.  The  probability  of  loss  is  thus  roughly  calculable 
on  the  basis  of  ( a )  the  variability  of  the  earnings,  ( b )  the  extent  of 
the  margin  of  safety,  and  ( c )  the  degree  of  specialization  of  the  capital. 
The  same  considerations  apply  to  the  purchase  of  real-estate  mort¬ 
gages,  and  to  loans  to  individuals. 

On  the  other  hand,  final  equities,  such  as  ownership  of  individual 
businesses  or  of  common  stocks  of  corporations,  have  their  speculative 
character  increased  by  the  creation  of  prior  liens.  In  the  case  cited 
above,  the  issuance  of  bonds  sufficient  to  absorb  25  per  cent  of  net 
income  in  fixed  charges  means  that  a  60  per  cent  shrinkage  in  net 
income  cuts  off  80  per  cent  of  the  stockholders’  return,  and  a  75  per 
cent  shrinkage  wipes  it  out  entirely.  The  thinner  the  equity  the 
greater  the  risk  to  both  parties.1  Common  stocks,  however,  are 
always  speculative,  even  if  preceded  by  no  prior  liens  of  any  kind; 
for  the  accumulated  assets  and  the  prospects  of  earnings  of  any  busi¬ 
ness,  no  matter  how  stable,  are  always  changing,  and  the  full  weight 

1  That  is,  provided  there  is  only  one  prior  lien.  The  bigger  the  first  mortgage 
bond  issue  the  more  the  risk  of  failure  to  earn  the  interest,  and  the  wider  the  relative 
range  of  fluctuation  of  the  remainder.  Issuing  a  junior  lien  bond  does  not  as  a  rule 
weaken  the  first  mortgage  bond. 


RISK  AND  THE  MANAGEMENT  OF  CAPITAL 


12 1 


of  these  changes  falls  on  the  common  stock.  Prior  liens  intensify 
the  risk;  they  do  not  create  it. 

In  this  connection  a  distinction  may  be  noted  between  the  customary 
adjustment  of  interest  rates  to  risk  in  the  market  for  long-time  loans  and 
in  that  for  short-time  loans.1  In  general,  commercial  money  lenders  do 
not  make  a  charge  for  interest  varying  with  the  assumed  degree  of 
risk  but  establish  a  single  rate  and  classify  applications  for  credit 
into  those  which  do  and  those  which  do  not  appear  safe  enough  to 
be  graded  at  this  rate.  In  the  investment  market,  on  the  other  hand, 
there  is  an  accurate  adjustment  of  the  interest  rate  to  the  assumed 
degree  of  risk,  so  that  in  the  same  market  the  rate  of  interest  on  bonds 
or  other  long-time  securities  varies  within  wide  limits  and  adjusts 
itself  to  very  minute  differences  in  the  security.2 

5.  The  return  to  makers  of  personal  loans  is  increased  by  the  lack  of 
general  knowledge  concerning  the  probability  of  repayment . — The  busi¬ 
ness  of  loaning  money  to  individuals  and  corporations  with  the 
expectation  of  early  repayment,  as  distinguished  from  relatively 
permanent  investment  through  the  purchase  of  stocks  or  bonds,  takes 
a  wide  variety  of  forms.  Its  most  important  form  is  the  extension 
pf  credit  to  business  men  by  banks,  but  it  also  includes  the  activities 
of  private  money  lenders,  discount  houses,  and  loan  sharks,  and  a 
vast  amount  of  lending  by  individuals  who  are  not  professional 
lenders  at  all.  In  general  it  may  be  said  that  loans  to  private  indi¬ 
viduals  and  businesses  of  moderate  size  are  apt  to  yield  a  higher  return 
in  proportion  to  the  risk  of  loss  than  that  obtainable  through  invest¬ 
ment  in  securities.  This  refers,  however,  to  the  risk  as  estimated  by 

1  In  the  strict  terminology  of  economics,  interest  contains  no  element  of  com¬ 
pensation  for  risk  for  the  reason  that  all  compensation  for  risk  is  treated  as  profit 
just  as  in  the  return  of  the  business  man  for  his  own  efforts  the  compensation  for 
his  services  is  treated  as  wages  and  “pr°fit”  includes  only  the  return  due  to  risk. 
In  the  ordinary  language  of  business,  however,  this  distinction  is  not  observed. 
Interest  is  the  return  paid  for  capital  invested  under  a  control  other  than  that  of 
the  owner  for  a  stipulated  return  (or  a  charge  against  one’s  own  capital  for  the 
interest  which  could  have  been  obtained  by  loaning  it  out).  Commercial  interest 
obviously  varies  with  the  estimated  degree  of  risk. 

2  This  difference  is  parallel  to  that  existing  between  the  practice  in  life  and  in 
fire  insurance.  In  life  insurance  a  single  normal  rate  is  established  and  most 
applications  are  either  accepted  or  rejected,  comparatively  little  attention  being 
given  by  most  companies  to  the  adjustment  of  rates  for  sub-standard  risks.  In 
fire  insurance,  on  the  other  hand,  there  is  an  adjustment  of  the  risk  premium  to 
almost  every  conceivable  degree  of  safety. 


122 


RISK  AND  RISK-BEARING 


the  comparatively  small  number  of  possible  lenders  who  are  able  to 
form  an  estimate  on  the  basis  of  adequate  information.  The  more 
widely  known  are  the  facts  concerning  the  financial  strength  and 
reliability  of  the  borrower,  assuming  that  his  record  is  good,  the 
more  closely  will  the  rate  he  is  obliged  to  pay  correspond  to  the  hazards 
involved  in  the  business  in  which  he  is  engaged.  If  the  number  of 
possible  lenders  whom  he  may  approach  is  small,  as  is  usually  the 
case,  he  is  less  likely  to  obtain  a  favorable  rate,  simply  because  of 
lack  of  competition  for  his  business.  Moreover,  the  time  risk  to  lenders 
is  greater  in  short-time  loans  than  in  security  investments,  not  only 
because  the  marketability  of  securities  enables  holders  to  withdraw 
their  capital  from  them  more  readily,  but  also  because  short-term 
borrowers  are  more  apt  than  are  corporations  to  be  slow  in  meeting 
their  obligations,  and  extensions  are  more  apt  to  be  necessary. 

Loans  secured  by  mortgages  on  real  estate  are  generally  considered 
the  safest  type  of  personal  loan  available  for  the  ordinary  lender. 
In  most  markets  these  yield  a  return  very  high  in  proportion  to  the  risk 
of  ultimate  loss.  They  lack  liquidity,  and  there  is  no  adequate  social 
machinery  for  securing  a  broad  market  for  them.  For  those  lenders 
who  do  not  need  a  high  degree  of  liquidity  in  their  investments  and 
are  able  to  assure  themselves  of  the  quality  of  the  mortgages  offered 
them,  they  frequently  form  the  ideal  investment.  It  should  be 
noted,  however,  that  the  return  on  such  loans  does  not  fluctuate  as 
much  as  on  most  classes  of  investments,  so  that  in  periods  of  high 
interest  rates  other  types  of  investment  become  relatively  more 
attractive. 

Uncertainty  as  to  time  of  repayment  of  loans  is  a  source  of  risk. — 
The  foregoing  discussion  has  reference  to  the  risk  of  loss  of  capital 
resulting  from  mistakes  of  investors  and  managers.  Another  risk  is 
involved  in  investments  of  capital,  however,  the  risk  that  one  will  not 
be  able  to  get  his  capital  back  at  the  time  he  wants  it  even  though  the 
investment  be  perfectly  good.  From  the  standpoint  of  the  debtor 
there  is  a  similar  risk  in  the  possibility  that  he  may  be  called  upon  to 
repay  the  loan  at  an  inconvenient  time.  Every  commercial  crisis 
results  in  numerous  financial  embarrassments,  arising  on  the  one  hand 
from  unexpected  failures  to  secure  renewals  of  loans  which  have  been 
counted  on  by  debtors,  and  on  the  other  hand  from  the  failure  of 
debtors  to  furnish  promptly  the  funds  which  have  been  counted  on  by 
creditors.  It  is  obvious  that  this  risk,  which  for  convenience  we  may 
call  time  risk ,  cannot  be  entirely  eliminated  so  long  as  we  employ  a 


RISK  AND  THE  MANAGEMENT  OF  CAPITAL 


123 


credit  system,  for  if  debtors  are  secure  against  having  to  repay 
advances  at  inconvenient  times,  creditors  cannot  at  the  same  time  be 
secure  against  the  risk  of  failure  to  collect  when  they  need  the  funds. 

All  that  can  be  done  is  to  adjust  the  interest  rate  to  fit  the  distri¬ 
bution  of  the  risk.  This  is  done  in  various  ways.  In  ordinary  bank 
deposits  the  time  risk  is  all  on  the  borrower — the  bank  must  repay 
the  loan  on  demand.  Consequently  depositors  can  expect  little  or  no 
interest  on  their  balances.  In  the  case  of  a  callable  bond,  i.e.,  a  bond 
which  may  be  called  in  for  payment  at  any  time  the  issuer  chooses  to 
do  so,  on  the  other  hand,  the  time  risk  is  all  on  the  lender.  So  great 
is  the  advantage  which  this  gives  the  borrower  that  callable  bonds 
cannot  be  sold  at  ordinary  rates  of  interest  except  by  making  them 
callable  at  a  price  somewhat  above  par.  Ordinary  call  loans1  can  be 
terminated  immediately  at  the  option  of  either  party.  Such  con¬ 
tracts  exhibit  the  greatest  variation  in  interest  rates.  Sometimes  the 
condition  of  the  market  is  such  that  the  callability  of  the  loan  makes 
it  very  desirable  from  the  lender’s  standpoint,  and  call  rates  are  very 
low.  At  other  times  the  demand  for  such  loans  far  outruns  the  supply 
and  the  rate  runs  up  to  figures  never  approached  in  any  other  type  of 
loan.  In  long-time  loans,  such  as  bonds  and  mortgage  loans,  the 
contract  cannot  be  terminated  by  either  party  without  the  consent  of 
the  other.  Time  risk  is  divided.  Here  again,  as  in  the  case  of  call 
loans,  the  rate  charged  depends  on  the  condition  of  the  market. 
Usually  a  large  number  of  lenders  prefer  to  carry  the  risk  of  wanting 
their  money  before  they  can  get  it  rather  than  the  risk  of  having  it 
repaid  before  they  want  it  on  their  hands.  Consequently  the  rate  on 
long-time  loans  tends  to  be  low.  When  rates  are  expected  to  rise, 
however,  the  time  risk  is  considered  heavier  from  the  lender’s  stand¬ 
point  on  the  long  loans  and  from  the  borrower’s  standpoint  on  the 
short  loans,  and  rates  on  long  loans  are  apt  to  be  higher. 

Incorporation  and  the  stock  exchange  make  possible  great  reduc¬ 
tion  in  this  sort  of  risk.  By  investing  in  a  bond  or  share  of  stock 
which  has  a  continuous  market,  the  investor  can  gain  most  of  the 
advantages  of  freedom  from  time  risk  which  are  afforded  by  call  loans, 
while  at  the  same  time  the  issuing  corporation  is  free  from  the  incon¬ 
venience  of  sudden  and  unexpected  calls  for  the  return  of  the  capital 
which  it  is  using.  Of  course,  the  investor  pays  for  this  advantage. 
A  security  which  is  readily  marketable  will  sell  at  a  higher  price,  or, 

1  Such  loans  are  common  in  this  country  only  in  the  financial  district  of  New 
York  City. 


124 


RISK  AND  RISK-BEARING 


to  state  the  same  thing  in  another  way,  will  yield  a  lower  rate  on  the 
investment.  Hence  it  is  important  for  the  investor  to  consider  before 
buying  a  security  whether  he  really  needs  the  advantages  of  market¬ 
ability.  If  he  does  not,  it  is  a  waste  of  money  to  pay  for  it. 

6.  Speculation  on  changes  in  prices  is  always  risky. — It  is  easy  to 
draw  a  distinction  between  “speculation”  and  “investment,”  but  it 
is  impossible  to  define  the  terms  with  such  accuracy  that  they  shall 
never  both  be  applicable  properly  to  the  same  transaction.  Col¬ 
loquially  the  terms  are  used  to  indicate  degrees  of  recognized  risk  and 
no  sharp  line  is  drawn  between  them.  The  one  shades  off  imper¬ 
ceptibly  into  the  other,  and  there  is  a  wide  area  of  common  ground 
along  the  border.  Nor  can  we  draw  the  line  sharply  so  long  as  we 
seek  an  external  test  in  the  form  of  the  transaction  or  the  character 
of  the  enterprise.  The  only  clear-cut  distinction  is  a  distinction  as  to 
the  purpose:  Is  the  transaction  intended  to  obtain  only  a  payment 
for  the  use  of  capital  invested  in  an  enterprise,  with  the  outcome 
fully  known  and  fully  taken  account  of,  or  is  there  an  attempt  to  realize 
an  economic  profit — to  get  more  in  return  than  we  could  if  all  parties 
to  the  transaction,  actual  and  potential,  were  certain  of  its  outcome  ? 
In  practice  pure  investment  in  this  sense  is  rare;  nearly  every  investor 
tries  to  combine  safety  with  some  degree  of  profit. 

Investment  and  speculation,  whether  in  land,  contracts,  com¬ 
modities,  or  securities,  involve  much  more  exclusive  attention  to  the 
problem  of  risk  reduction  than  do  most  types  of  business  activity. 
From  the  “shoestring”  speculator,  who  tries  to  make  a  living  without 
work  by  guessing  the  hourly  fluctuations  of  the  Curb  price  of  an  oil 
stock,  to  the  president  of  a  trust  company,  who  shifts  the  proportion 
of  railroad  bonds  and  short-term  paper  in  his  holdings  in  accordance 
with  his  judgment  of  the  future  course  of  the  interest  rate,  the  whole 
army  of  investors  and  speculators  are  engaged  in  risk  bearing;  that 
is,  in  an  attempt  to  profit  by  the  uncertainty  in  other  men’s  minds 
and  to  get  a  better  return  for  the  use  of  their  capital  than  they  could 
if  those  from  whom  they  buy  and  to  whom  they  sell  had  as  good 
knowledge  of  the  present  and  as  good  judgment  of  the  future  as  they 
themselves  possess. 

Success  in  all  these  lines  depends  on  ability  to  forecast  price 
changes,  which  in  turn  depends  upon  ability  to  weigh  the  importance 
of  complicated  and  conflicting  indications  of  the  movement  of  demand 
and  supply,  not  with  absolute  accuracy,  but  with  greater  accuracy 
than  someone  else  does  it.  All  speculation  on  the  price  of  anything  is 


RISK  AND  THE  MANAGEMENT  OF  CAPITAL 


125 


essentially  a  contest.  For  we  cannot  buy  except  at  a  price  at  which 
someone  else  considers  the  commodity  or  security  a  good  sale,  and 
we  cannot  sell  except  at  a  price  which  someone  else  considers  to 
offer  value  for  his  money.  Whatever  the  price  is,  that  price  repre¬ 
sents  the  consensus  of  market  opinion  at  the  moment  as  to  what 
the  price  ought  to  be,  and  the  attempt  to  make  a  speculative  profit 
is  a  matching  of  one’s  knowledge,  judgment,  skill,  and  luck  against 
the  composite  judgment  of  the  world.  Risk  is  not  merely  incidental 
to  this  type  of  enterprise;  it  is  of  the  essence. 

For  this  reason  all  speculative  activity  is  often  condemned  by 
moralists  as  a  species  of  gambling.  Speculation  is  not  a  form  of  gam¬ 
bling;  gambling  is  a  form  of  speculation.  All  forms  of  speculation 
are  attempts  to  secure  profits,  to  get  for  the  service  of  one’s  capital 
(or  labor)  more  than  they  are  worth;  that  is,  more  than  they  would 
be  worth  if  the  relevant  facts  were  generally  known  and  account  taken 
of  them. 

7.  Gambling  is  speculating  on  artificial  risks. — The  only  thing  which 
differentiates  gambling  from  “legitimate”  speculation  (hereafter 
referred  to  for  brevity’s  sake  as  speculation)  is  that  in  speculation 
the  risks  are  inherent  risks  of  industry,  and  must  be  borne  by  someone 
if  production  is  to  go  on.  The  speculator  who  buys  a  carload  of  sugar 
and  holds  it  for  a  rise  carries  a  risk  which  he  need  not  carry,  but  which 
someone  must;  the  more  efficiently  he  judges  the  trend  of  the  market, 
the  less  will  the  price  fluctuations  be.  One  speculator  gains  what 
another  loses,  but  the  gain  of  the  first  does  not  cause  the  loss  of  the 
second.1 

In  gambling,  on  the  other  hand,  nothing  of  this  sort  is  true.  The 
risk  is  'an  artificial  risk,  created  by  the  gambling  transaction  itself. 
Risk  is  increased  for  the  sake  of  the  risk  and  for  the  sake  of  profiting 
by  one’s  luck  and  skill  at  the  expense  of  another.  The  losses  of  the 
unsuccessful  are  not  compensated  for  by  any  gain  to  themselves, 
except  the  direct  utility  of  the  excitement. 

1  Indeed  it  tends  slightly  to  decrease  it.  If  A  buys  at  the  bottom  and  sells  at 
the  top,  his  operations  make  the  bottom  a  little  higher  and  the  top  a  little  lower 
than  it  would  otherwise  have  been,  and  so  reduce  the  losses  of  B,  who  buys  at  the 
top  and  sells  at  the  bottom.  However,  it  should  be  noted  that  this  analysis  of 
speculation  is  partial.  Certain  risks  are  increased  by  the  fact  that  speculators  have 
an  interest  in  concealing  the  true  situation  from  one  another.  Moreover,  the 
inflation  of  the  volume  of  trade  through  short  sales  multiplies  the  points  at  which 
risk  appears.  The  whole  question  will  be  discussed  more  fully  in  a  later  section. 
See  chap,  xviii. 


126 


RISK  AND  RISK-BEARING 


Except  for  the  few  who  possess  superior  information  concerning  the 
probabilities  of  a  favorable  outcome ,  gambling  enterprises  involve  a 
greater  risk  than  is  justified  by  the  chance  of  profit. — We  are  not  con¬ 
cerned  at  this  point  with  the  sporting  type  of  gambler  who  engages 
in  betting  as  a  form  of  recreation  and  counts  his  losses  a  fair  payment 
for  the  amusement  he  receives.  Nor  are  we  concerned  with  the  pro¬ 
fessional  gambling-house  keeper  who  runs  his  game  squarely  and 
obtains  his  profit  from  a  “ percentage”  in  favor  of  the  “house.”  He  is 
a  business  man  engaged  in  selling  amusement  for  a  price,  and  so 
long  as  he  plays  the  game  squarely  and  the  odds  in  favor  of  the  house 
are  known  to  his  patrons,  they  have  no  cause  to  revile  him  for  their 
inevitable  final  misfortunes.  Finally,  we  are  not  concerned  with  the 
“gambler,”  professional  or  otherwise,  who  creates  a  probability  in 
his  own  favor  by  cheating.  As  in  any  other  type  of  dishonesty,  the 
man  who  is  skilful  is  likely  to  find  that  the  risks  of  his  business  and  the 
social  disapproval  with  which  it  is  affected  serve  to  keep  down  com¬ 
petition  and  make  his  profits  relatively  large.  The  point  at  issue  here 
is  the  financial  soundness  of  true  gambling  transactions,  that  is,  of 
the  staking  of  money  on  events  whose  outcome  is  uncertain,  as  a 
method  of  securing  income. 

In  such  cases  the  gambler’s  decision  to  risk  his  money  on  a  certain 
outcome  is  determined  by  a  consideration  of  the  odds  offered  as  com¬ 
pared  with  his  judgment  of  the  relative  probabilities  of  the  alternative 
possible  outcomes.  Gamblers  as  a  class  cannot  win,  but  the  indi¬ 
vidual  gambler  whose  judgment  is  better  than  the  average  of  the  group 
whose  decisions  determine  the  odds  is  sure  to  make  money  in  the  long 
run;  provided,  first,  that  his  stake  in  any  one  transaction  is  so  small 
that  no  accidental  adverse  run  cripples  him;  and,  second,  that  he 
resists  the  temptation  to  enlarge  his  scale  of  operations  after  each 
successful  venture  and  decrease  it  after  the  unsuccessful  one.  As  a 
matter  of  fact,  the  probability  of  a  given  individual’s  attaining  success 
in  an  effort  to  make  money  continuously  out  of  gambling  transactions 
is  of  very  much  the  same  sort  as  his  chance  of  making  money  by 
taking  advantage  of  any  kind  of  price  fluctuations.  In  the  one 
case  the  prices,  in  the  other  case  the  odds,  are  the  result  of  a  composite 
judgment  of  the  entire  group  of  persons  who  are  trying  to  piofit 
by  their  forecasting  skill;  in  each  case  success  depends  upon  one’s 
relative  ability  to  form  a  correct  judgment  as  to  the  probability  of  a 
given  outcome,  relative  that  is  to  the  ability  of  the  rest  of  the  group 
to  form  similar  judgments.  So  far  as  the  kind  and  degree  of  risk 


RISK  AND  THE  MANAGEMENT  OF  CAPITAL 


127 


are  concerned,  the  respective  chances  of  the  man  who  takes  “flyers,” 
trusting  wholly  to  his  luck,  the  man  who  relies  on  the  current  gossip  to 
obtain  a  basis  of  judgment,  and  the  man  who  bases  his  operations  on 
a  careful  study  of  all  available  information,  are  about  the  same  in  the 
wheat  pit,  the  land  market,  the  stock  exchange,  and  on  the  race 
track.  In  each  case,  in  the  absence  of  “inside  information”  or  of 
some  method  of  controlling  the  outcome  of  the  event,  risk  even  to  the 
most  careful  student  is  very  great,  while  the  chances  of  the  average 
man’s  attaining  consistent  success  are  negligibly  small.1 

QUESTIONS 

1.  Are  losses  smaller  in  a  diversified  list  of  investments?  Is  risk  less? 

2.  “Gambling  is  a  form  of  speculation.”  Explain. 

3.  What  is  the  character  of  the  “time  risk”  in  a  purchase  of  real  estate 
mortgages  ?  in  a  purchase  of  well-known  speculative  stocks  ?  in  a  purchase 
of  a  life  annuity  ? 

4.  Explain  the  relationship  between  limited  liability  and  the  diversification 
of  investments. 

1  Attention  is  given  to  the  social  and  moral  aspects  of  gambling  in  chapter  xviii. 
The  methods  used  in  analyzing  the  trend  of  speculative  markets  are  considered 
in  chapters  ix  and  x. 


CHAPTER  VIII 

THE  SECURITY  MARKETS 

As  was  indicated  in  chapter  vii,  the  place  in  our  business  system 
where  the  attention  of  the  profit-seeker  is  most  closely  centered  on 
the  problem  of  reducing  risk  through  the  elimination  of  uncertainty 
is  in  the  field  of  speculation  and  investment.  For  this  reason  the  sub¬ 
ject  is  given  detailed  attention  in  this  and  the  following  chapters. 
We  will  first  survey  the  organization  of  the  securities  market  and  the 
technical  devices  used  in  speculative  and  investment  operations.  This 
will  be  followed  by  a  survey  of  the  methods  used  by  operators  in  these 
markets  in  deciding  when  to  buy  and  when  to  sell,  chapter  ix  dealing 
with  speculative  operations  and  chapter  x  with  those  of  a  more  con¬ 
servative  character.  Finally,  in  chapter  xi  we  will  examine  the 
speculative  markets  for  commodities,  and  the  methods  used  in 
operating  through  them. 

I.  THE  MARKET  FOR  OLD  SECURITIES 

The  market  for  old  securities  presents  the  widest  variation  in  char¬ 
acter.  At  the  one  extreme  are  the  securities  of  thousands  of  corpora¬ 
tions  for  which  there  is  no  quotable  market  whatever.  The  investors 
who  hold  the  stocks  or  bonds  of  these  corporations  are  practically 
in  the  position  of  partners  in  the  enterprises,  so  far  as  their  ability 
to  liquidate  their  holdings  is  concerned.  At  the  other  extreme,  in 
marketability,  are  a  dozen  or  more  of  the  most  active  stocks  which  it 
is  possible  to  buy  or  sell  in  lots  of  anywhere  from  one  to  a  thousand 
shares  with  only  a  fraction  of  a  per  cent’s  variation  in  the  price. 
Between  these  extremes  there  are  all  degrees  of  marketability. 

The  most  conspicuous  institution  which  has  been  developed  for 
the  purpose  of  facilitating  trade  in  old  securities  is  the  stock  exchange, 
and  the  market  for  active  securities  can  therefore  be  understood  best 
through  a  study  of  the  organization  and  work  of  a  typical  exchange. 
The  New  York  Stock  Exchange  will  be  described  in  considerable 
detail  for  the  reason  that  its  activities  completely  overshadow  those 
of  the  other  stock  exchanges  of  the  United  States.  Other  exchanges 
will  be  described  more  briefly. 


128 


THE  SECURITY  MARKETS 


129 


The  New  York  Stock  Exchange  is  a  voluntary  association  whose 
purpose  is  to  facilitate  the  purchase  and  sale  of  securities  by  its  members. — 
The  fact  must  be  emphasized  at  the  outset  that  the  Exchange  is  an 
organization  formed  by  a  limited  group  of  individuals  to  advance  their 
own  business  interests.  Its  principal  function  is  to  help  its  members 
to  buy  and  sell  stocks  and  bonds  with  the  minimum  expenditure  of 
time  and  labor,  and  with  the  maximum  amount  of  relevant  informa¬ 
tion  to  guide  their  decisions.  Incidentally  it  renders  numerous  other 
services,  not  only  for  its  members  but  for  the  public,  but  these  other 
services  are  supplemental  to,  rather  than  independent  of,  its  principal 
business.  The  Exchange  itself  does  not  buy  nor  sell  securities,  nor, 
except  in  rare  emergencies,  does  it  place  any  restrictions  upon  the 
prices  at  which  trades  are  made,  or  influence  them  in  any  direct  way. 
It  is  not  its  business  to  direct  the  flow  of  investment,  nor  to  furnish 
the  public  with  a  barometer  of  prosperity,  nor  to  protect  speculators 
from  their  own  folly  or  investors  from  the  dishonesty  or  incapacity 
of  the  managers  of  their  property. 

More  specifically,  the  Exchange’s  functions  are  the  following: 

1.  It  furnishes  a  place  of  meeting  for  traders. 

2.  It  prescribes  standard  types  of  contract  and  rules  of  interpreta¬ 
tion,  the  provisions  of  which  are  implied  in  all  trades  made  on  the 
floor  of  the  Exchange;  and  provides  rules  for  conducting  its  business 
in  an  orderly  way. 

3.  It  regulates  the  business  methods  of  those  of  its  members 
who  are  engaged  in  brokerage. 

4.  It  provides  facilities  for  “clearing”  trades,  thus  reducing  the 
labor  of  delivery  of  securities  and  payment  for  them. 

5.  It  furnishes  an  elaborate  equipment  for  obtaining  and  dis¬ 
seminating  information. 

6.  It  attempts  to  influence  legislation  and  the  growth  of  public 
opinion  in  ways  favorable  to  the  interests  of  its  members,  and  combats 
the  activities  of  “bucket  shops”  and  other  agencies  which  tend  to 
injure  or  discredit  the  business  of  legitimate  brokerage,  investment, 
and  speculation. 

1.  The  Exchange  furnishes  a  meeting  place  for  traders. — The  pro¬ 
vision  of  a  place  to  carry  on  trade  is  perhaps  the  most  important,  as 
well  as  the  earliest,  function  performed  by  an  organized  exchange. 
In  an  early  stage  of  the  development  of  a  security  market,  brokers, 
dealers,  and  private  investors  can  get  in  touch  with  one  another  by 
correspondence,  by  advertising,  or  by  making  the  rounds  of  the 


130 


RISK  AND  RISK-BEARING 


financial  district  in  person.  Telephone  and  telegraph  also  still  serve 
even  in  the  largest  markets  to  make  possible  an  immense  volume  of 
trading  without  the  use  of  an  exchange.  As  the  number  of  professional 
brokers  in  a  city  increases,  however,  it  becomes  desirable  for  them  to 
get  together  for  a  part  of  the  day  to  match  their  orders.  A  large 
office  or  the  lobby  of  some  convenient  hotel  may  serve  for  a  time  as 
a  meeting  place.  'In  New  York  the  Broad  Street  Curb  served  for 
many  years  as  a  meeting  place  for  dealers  in  certain  stocks  (see 
below,  p.  147),  while  the  original  meeting  place  of  the  New  York 
Stock  Exchange  was  under  a  tree  in  Wall  Street.  Increasing  numbers 
made  it  necessary  in  New  York,  as  they  have  at  many  other  points, 
to  adopt  some  formal  organization  to  share  the  responsibility  and 
expense  of  maintaining  a  regular  meeting  place. 

2.  The  Exchange  exercises  control  over  trading. — Once  the  practice 
of  meeting  to  trade  is  begun,  it  becomes  necessary  immediately  to 
regulate  to  some  extent  the  trade  carried  on  in  the  common  place  of 
meeting.  Hours  of  trading  are  prescribed,  and  penalties  fixed  for 
trading  in  listed  securities  outside  these  hours.  On  the  New  York 
Exchange,  the  present  hours  are  from  ten  to  three  (on  Saturday  from 
ten  to  twelve),  and  outside  trading  (in  listed  securities)  is  punished 
by  fines.  The  object  of  the  penalty  for  outside  trading  is  twofold: 
first,  it  insures  to  every  member  a  fairer  chance  at  other  members’ 
offerings,  and  second,  it  restrains  the  severity  of  competition  between 
brokers. 

The  manner  of  executing  trades  is  regulated  in  some  detail.  The 
standard  unit  of  trading  is  100  shares,  and  all  bids  and  offers  are  under¬ 
stood  to  be  for  that  amount,  unless  otherwise  specified.  Moreover, 
anyone  who  makes  a  bid  or  offer  for  a  larger  amount  must  accept  a 
trade  for  100  shares  or  any  multiple  thereof  smaller  than  his  offer. 
Offers  not  otherwise  designated  are  understood  to  be  “regular  way,” 
that  is,  delivery  and  payment  to  be  made  on  the  next  business  day, 
except  that  deliveries  on  Friday  trades  are  made  on  Monday.  Trades 
may  be  made  also  for  “cash,”  that  is,  delivery  and  payment  same 
day,  or  “seller  three,”  “seller  thirty,”  “buyer  sixty,”  etc.,  which 
means  that  the  seller  has  three,  thirty,  or  sixty  days  within  which 
to  make  delivery,  or  the  buyer  to  call  for  delivery,  as  the  case  may  be. 
Such  dealings  are  not  frequent.1 

1  During  the  early  days  of  the  Great  War  a  great  many  sales  were  made  “seller 
thirty”  in  order  to  allow  time  for  importation  of  certificates. 


THE  SECURITY  MARKETS 


13 1 

“  Wash  sales,”  that  is,  trades  where  the  buyer  and  seller  are  identi¬ 
cal,  are  prohibited,  but  the  prohibition  is  difficult  of  enforcement,  for 
the  broker  has  usually  no  way  of  knowing  whether  his  principal  is 
also  trading  through  another  member.  “Cornering”  and  other 
obvious  ways  of  establishing  an  artificial  price  are  also  prohibited. 
All  offers  must  be  open  for  acceptance  by  any  other  member. 

3.  Relations  of  brokers  with  customers  are  regulated. — The  most 
important  rule  governing  the  relations  of  brokers  and  their  principals 
is  the  stringent  rule  against  cutting  commissions,  the  object  of  which 
is  obvious.  There  are  also  rules  requiring  the  broker  to  make  good 
to  clients  the  losses  resulting  from  errors  on  the  broker’s  part,  and 
from  failure  to  obtain  the  proper  execution  of  orders;  rules  prohibiting 
the  filling  of  orders  from  the  broker’s  own  stock,  and  similar  regula¬ 
tions  designed  to  maintain  the  reputation  of  the  Exchange  as  a  home 
of  fair  dealing. 

4.  Delivery  of  stock  is  simplified. — The  delivery  system  of  the 
New  York  Stock  Exchange  is  one  of  the  most  efficient  in  the  world. 
Its  operation  in  brief  is  as  follows:  Since  delivery  of  stock  must  be 
made  daily,  it  is  impossible  for  all  transfers  of  ownership  of  active 
stocks  to  be  recorded  on  the  books  of  the  issuing  corporations.  Stock 
certificates  are  transferable  by  indorsement,  and  in  the  case  of  active 
speculative  securities  certificates  issued  in  the  name  of  brokerage 
houses  and  indorsed  in  blank  are  frequently  exchanged  by  mere 
delivery  of  the  certificate.  In  the  case  of  dividend  paying  stocks, 
this  results  in  the  dividends  being  paid  to  houses  which  are  not  the 
actual  owners  of  the  stock,  and  it  is  the  business  of  the  broker  who 
owns  stock  at  the  time  it  “goes  ex-dividend”  to  collect  the  dividend 
from  the  one  to  whom  it  is  paid.  In  the  case  of  non-dividend  stocks, 
no  inconvenience  results  from  leaving  the  stock  in  “street  name,” 
and  frequently  the  stock  is  so  left  even  when  bought  by  investors  and 
taken  out  of  the  market. 

The  most  important  device  for  reducing  the  labor  connected  with 
the  •  delivery  of  stocks  is  the  Stock  Clearing  Corporation.  This 
organization  functions  in  two  branches,  known  respectively  as  the 
night-clearing  and  the  day-clearing  branches.  The  night-clearing 
branch  receives  from  brokers  reports  of  the  stock  bought  and  sold 
during  each  trading  day,  and  makes  up  a  schedule  of  deliveries  so 
that  settlement  can  be  effected  with  the  minimum  of  labor.  Thus, 
if  A  has  sold  a  certain  security  to  B,  and  B  to  C,  and  C  to  D,  A  may 
be  directed  to  deliver  the  security  direct  to  D.  D  will  then  make 


132 


RISK  AND  RISK-BEARING 


payment  to  A  at  an  arbitrary  settlement  price  which  is  established 
each  day  as  a  basis  for  that  day’s  settlements.  If  in  the  foregoing 
illustration  A  has  sold,  say,  Southern  Pacific  stock  at  90,  B  at  91,  and 
C  at  92,  and  the  “ settlement  price”  is  93,  A  will  deliver  the  stock  to 
D  and  collect  $93  a  share.  The  differences  between  the  contract 
price  and  the  clearing  price  are  settled  between  the  clearing  members 
and  the  clearing  corporation.  A,  having  sold  at  90  and  collected  $93, 
will  owe  the  clearing  corporation  $3  per  share  B,  having  bought  at 
91  and  sold  at  92,  will  have  a  claim  on  the  clearing  house  for  $1  per 
share.  C,  likewise,  has  a  claim  for  $1  per  share  and  D,  having  bought 
at  92  and  made  payment  at  93,  has  a  claim  to  $1.  The  clearing 
house,  therefore,  collects  $3  from  A,  and  pays  $1  to  each  of  the  other 
three.  Thus,  a  member  who  has  bought  and  sold  the  same  amount 
during  the  day  is  relieved  of  all  responsibility  for  delivery  and  pay¬ 
ment  except  the  collecting  of  profits  or  the  payment  of  losses,  and  an 
enormous  saving  of  labor  in  the  certification  and  payment  of  checks 
is  effected. 

Systems  substantially  the  same  as  this  are  used  in  most  of  the 
stock  exchanges  throughout  the  country.  In  New  York,  however, 
a  unique  feature  was  added  in  1920,  a  second  clearing  system,  known 
as  the  day  clearing,  for  settling  the  balances  due  between  traders 
who  accept  and  deliver  stocks.  Thus,  in  the  foregoing  illustration  D 
owed  A  a  balance  of  $93  per  share  on  delivery  of  the  stock.  Quite 
probably,  however,  A  owed  a  similar  balance  to  E  on  other  transac¬ 
tions,  E  to  F,  and  F  to  D.  By  reporting  to  the  clearing  house  the 
balance  due  and  paying  in,  or  drawing  out,  the  net  balance  of  pay¬ 
ments,  a  second  material  reduction  of  the  labor  connected  with 
check  certification  and  deposit  is  effected.  This  second  operation  is 
worked  out  during  the  day  following  the  delivery  in  the  morning  of 
stocks  which  have  been  bought  and  sold  the  previous  day.  This 
secondary  clearing  operation  is  unknown  in  the  lesser  stock  exchanges 
of  the  country. 

5.  The  Exchange  assists  its  members  in  securing  information. — 
The  Exchange’s  service  in  providing  its  members  with  information 
consists  chiefly  of  two  activities,  namely,  the  quotation  service  and 
the  requirement  of  publicity  from  corporations  whose  securities  are 
listed.  The  quotation  service  has  been  described  as  follows: 

In  among  the  posts  are  four  “pedestals,”  each  bearing  the  regulation 
“ticker”  and  a  telegraph  key.  These  are  the  sending  stations  of  the  great 
ticker  service  that  records  in  brokers’  offices  and  banks  all  over  the  country 


THE  SECURITY  MARKETS 


133 


each  sale  of  stock  as  it  is  completed  on  the  New  York  Stock  Exchange. 
When  the  Exchange  has  opened,  we  shall  see  scattered  about  the  floor 
uniformed  attendants,  each  wearing  on  his  cap  a  broad  gold  band  and  a 
plate  with  the  word  “reporter”  on  it.  At  intervals,  more  or  less  frequent 
as  business  waxes  and  wanes,  the  reporters  converge  upon  the  pedestals 
and  hand  to  one  of  their  number  at  the  telegraph  key  slips  on  which  they 
have  hurriedly  penciled  the  particulars  of  sales  which  they  have  just  heard 
made  in  the  crowds  about  the  different  posts.  Briskly  the  reports  they 
bring  in  are  “pounded  out”  by  the  man  at  the  key,  and  back  they  dart  to 
eavesdrop  again.  In  two  rooms  on  the  top  floor  of  the  building  is  to  be 
found  the  next  stage  in  the  ticker  service.  One  is  occupied  by  the  New 
York  Quotation  Company,  which  is  controlled  by  the  Stock  Exchange,  the 
other  by  the  Gold  and  Stock  Quotation  Company,  a  subsidiary  of  the 
Western  Union.  The  first  supplies  the  reports  of  the  transactions  on  the 
Floor  to  the  offices  of  members  of  the  Exchange  below  Chambers  Street; 
the  second  to  all  the  other  tickers  in  New  York  and  in  fifty  cities  throughout 
the  country. 

In  each  room  sit  two  groups  of  men,  one  active,  the  others  in  reserve. 
There  are  five  men  to  a  team.  One  sits  before  a  round  disc  studded  with 
red  and  white  push-buttons  lettered  and  numbered  like  the  keys  of  a  type¬ 
writer.  The  other  four  sit  around  him,  each  with  one  ear  close  to  a  telegraph 
sounder  in  its  wooden  box.  The  wires  to  each  sounder  are  the  wires  com¬ 
ing  from  one  of  the  four  pedestals  downstairs.  As  first  one  then  another 
of  the  instruments  chatters  out  a  metallic  message  of  some  sale  on  the 
Floor,  the  central  operator's  hands  with  their  long,  facile  fingers  spell  out 
the  message  again  on  the  buttons  before  him.  He  has  taken  the  message 
“by  ear,”  as  he  regularly  does  in  dull  times  when  selling  is  slow  and  only 
one  sounder  speaks  at  a  time.  But  the  listening  operator  whose  instrument 
has  spoken  also  writes  the  particulars  of  the  sale  on  a  slip  of  paper  and 
sets  it  before  his  partner.  In  quiet  times  this  is  only  necessary  in  order 
to  help  the  sending  operator  in  checking  his  work.  On  busy  days,  however, 
it  saves  him  from  the  impossible  task  of  listening  to  four  instruments  at 
once  and  disentangling  their  dots  and  dashes. 

As  he  spells  out  each  sale  on  the  red  and  white  buttons  the  ticker  on 
the  table  before  him  prints  on  the  tape  the  record  US  57!  U  145!  K  500.20 
Pa  108  BO  200.97  K  20  R  i6f  U  145!  MP  315.  As  we  watch  the  record 
grow  on  the  marching  tape  we  know  that  on  just  such  a  tape  at  precisely 
the  same  instant  in  500  offices  precisely  the  same  record  is  being  printed. 
In  the  next  room  the  same  process  is  sending  the  same  word  to  probably 
ten  thousand  offices  and  banks  in  fifty  cities  and  towns  of  the  country. 

Like  the  winking  blackboards  on  the  walls  downstairs,  these  rooms, 
with  their  staccato  sounders  and  the  nimble  fingers  of  the  operators  playing 
on  their  parti-colored  discs,  seem  symbolic  too.  They  remind  us  that  every 
transaction  on  the  Floor,  every  purchase,  every  sale,  is  known  to  the 


134 


RISK  AND  RISK-BEARING 


public  hardly  more  than  an  instant  after  it  is  made.  It  is  little  exaggera¬ 
tion  to  say  that  a  sale  of  stock  is  reported  all  over  the  city  before  the  brokers 
who  take  part  in  it  have  had  time  to  record  it  on  their  pads.  The  reporter 
hears  the  offer,  catches  the  word  “sold”  or  sees  the  gesture  which  closes  the 
transaction,  walks  twenty  feet  across  the  Floor  to  the  nearest  pedestal  and 
taps  out  the  report  on  the  telegraphic  key.  Upstairs  the  operator  at  the 
disc  catches  the  message  “by  ear,”  spells  it  out  on  the  buttons,  and  before 
the  buying  and  selling  members  have  gathered  themselves  together  for  the 
next  trade  the  ticker  in  every  broker’s  office  in  the  Street  has  printed  the 
fact  on  the  tape. 

In  busy  times  the  ticker  does  fall  behind  the  market,  but  on  an  ordinary 
day  it  is  not  behind  at  all.  The  swiftness  of  the  electric  current  and  the 
rapidity  of  the  trained  workers  who  bridge  the  gaps  in  the  circuit  keep  the 
ticker  service  well  abreast  in  the  market.  The  man  who  has  given  an  order 
to  his  broker  to  buy  500  Steel  at  60,  if  he  only  stays  near  a  ticker  can 
know  when  the  market  has  reached  his  price,  and  his  stock  presumably  been 
bought,  much  sooner  than,  if  he  were  buying  a  dozen  eggs,  the  grocer  could 
have  them  wrapped  up  for  him. 

The  Stock  Exchange  does  its  business  in  the  open.  The  public  knows 
what  has  happened  there  just  as  quickly  as  the  members  on  the  Floor. 
No  trades  are  concealed;  no  news  of  trades  delayed;  no  prices  made  or 
broken  without  instant  word  going  to  every  part  of  the  land.  Of  course 
this  is  not  to  say  that  the  reasons  for  each  sale,  the  forces  behind  it,  the 
meaning  of  each  movement  in  price,  of  each  “bulge”  or  “break,”  are  trans¬ 
mitted  to  the  public.  They  are  not  known  even  to  the  members  themselves 
except  by  inference  and  deduction  and  guesswork.  The  Stock  Exchange  no 
more  than  any  other  organization  of  men  can  penetrate  the  individual  mind 
and  heart  and  determine  infallibly  and  instantaneously  why  the  individual 
performs  a  given  act.  How,  then,  can  it  tell  the  public  why  a  certain  thing 
happens  and  what  the  happening  portends?  But  it  can  tell  the  public 
just  what  does  happen,  and  it  does  so  with  astonishing  suddenness.  It  is 
hard  to  see  how  a  more  complete  and  instantaneous  mechanism  for  spread¬ 
ing  broadcast  the  news  of  the  course  of  business  in  a  given  field  could  be 
devised.  What  the  Stock  Exchange  does  the  country  knows,  and  knows  it 
the  next  moment.1 

It  may  be  added  that  the  Exchange’s  control  of  quotations  is 
used  not  merely  to  enable  it  to  furnish  a  valuable  service  to  its  mem¬ 
bers,  but  also  as  a  source  of  considerable  revenue  and  as  a  means  of 
controlling  certain  activities  of  individuals  not  members  of  the 
Exchange.  For  though  ticker  privileges  are  sold  to  non-members,  the 

1  Adapted  by  permission  from  H.  Howland,  “  Gambling  Joint  or  Market 
Place,”  Outlook ,  June  28,  1913,  pp.  423-25. 


THE  SECURITY  MARKETS 


T35 


Exchange  retains  the  right  to  refuse  quotation  to  bucket  shops1 
and  others  whose  use  of  the  quotations  is  calculated  to  bring  discredit 
on  the  business  of  the  Exchange. 

The  other  chief  means  of  securing  information  for  the  benefit  of 
members  and  their  clients  is  found  in  the  rules  governing  the  listing 
of  securities.  The  Stock  Exchange  maintains  a  committee  on  stock 
listing,  whose  business  is  to  receive  and  consider  applications  for 
placing  securities  on  the  list  and  make  recommendations  concerning 
them  to  the  governing  committee,  or  in  the  case  of  certain  high-grade 
securities,  to  list  them  without  reference  to  the  governing  committee. 
The  requirements  for  listing  are  extremely  strict.  The  corporation 
applying  for  the  listing  of  its  stock  must  file  a  statement  showing,  in 
addition  to  the  ordinary  information  concerning  its  charter,  form  of 
capitalization,  and  field  of  business,  complete  details  concerning  its 
financial  structure  and  financial  strength.  This  includes  such  detailed 
information  as: 

A.  Voting  power  of  obligations  of  debt. 

B.  (i)  Purpose  of  issue;  (2)  application  of  proceeds;  (3)  amount  issued 
for  securities,  contracts,  property;  description  and  disposition;  (4)  addi¬ 
tional  property  to  be  acquired. 

C.  Tabulated  list  of  constituent,  subsidiary,  owned,  or  controlled 
companies  showing  (a)  date  of  organization;  ( b )  where  incorporated;  ( c ) 
duration  of  charter;  ( d )  business,  and  ( e )  capital  stock  issues  (by  classes), 
par  value,  amount  authorized,  issued,  owned  by  parent  company. 

D.  (1)  Mortgage,  and  (2)  other  indebtedness,  ( a )  date,  ( b )  maturity, 
( c )  interest  rate,  ( d )  redemption  by  sinking  fund  or  otherwise,  ( e )  amount 
authorized,  and  (/)  amount  issued;  (3)  similar  information  regarding 
mortgage  and  all  indebtedness  of  constituent,  subsidiary,  owned,  or 
controlled  companies. 

Other  liabilities  in  detail,  description  of  property  owned  in  fee,  con¬ 
trolled,  or  leased. 

Policy  as  to  depreciation. 

Output  or  production  for  the  preceding  five  years,  dividends  paid, 
income  account,  balance  sheet,  and  similar  accountings  for  predecessor, 
constituent,  subsidiary,  owned  or  controlled  companies  and  corporations 
recently  consolidated.2 

The  corporation  must  also  agree  not  to  dispose  of  its  stock  interest 
in  subsidiaries,  except  under  existing  authority  or  on  direct  authoriza- 

1  A  bucket  shop  is  an  organization  posing  as  a  commission  house  which  executes 
fictitious  trades  for  customers,  paying  them  their  profits  or  pocket  ing  their  losses 

2  Adapted  from  Rules  of  the  New  York  Stock  Exchange ,  reprinted  in  J.  E. 
Meeker,  The  Work  of  the  Stock  Exchange,  pp.  577  ff. 


1 36 


RISK  AND  RISK  BEARING 


tion  of  stockholders,  to  publish  at  least  once  a  year  an  income  account 
and  balance  sheet,  to  maintain  a  transfer  and  registry  office  in  New 
York  City,  to  notify  the  Exchange  of  any  change  of  capitalization, 
to  publish  promptly  any  action  in  respect  to  interest  on  bonds,  divi¬ 
dends,  or  allotment  of  rights,  and  to  have  on  hand  at  all  times  a 
sufficient  supply  of  certificates  to  meet  the  demands  for  transfer. 

These  provisions  are  intended  to  secure  adequate  publicity  for 
the  business  of  the  corporation,  and  to  enable  investors  to  form  an 
intelligent  estimate  in  regard  to  their  value.  The  provisions  control¬ 
ling  the  listing  of  new  securities  are  much  more  adequate  for  this 
purpose  than  are  the  provisions  controlling  corporations  whose  stocks 
have  been  listed.  Once  the  securities  of  a  corporation  have  been 
placed  upon  the  list,  the  Exchange,  as  a  matter  of  fact,  exercises  very 
little  supervision  over  the  management  of  the  business,  so  long  as 
investors  are  notified  promptly  of  the  declaration  and  passing  of 
dividends,  issuance  of  rights,  suspension  of  interest  payments,  and 
similar  necessary  data.  Even  the  requirement  that  an  annual  income 
statement  and  balance  sheet  be  published  is  not  rigidly  enforced, 
though  nearly  all  corporations  whose  securities  are  listed  do,  as  a 
matter  of  fact,  publish  this  information. 

Control  of  the  Exchange  is  highly  centralized. — The  Stock  Exchange 
is  controlled  by  a  Governing  Committee  of  forty  members  together 
with  the  president  and  treasurer  of  the  Exchange.  This  committee 
has  practically  absolute  power  not  only  to  lay  down  rules  for  trading 
but  to  discipline  members  by  fines,  suspension,  and  expulsion.  Sub¬ 
ordinate  to  the  Governing  Committee  are  a  number  of  special  com¬ 
mittees  composed  of  members  of  the  Governing  Committee  and 
appointed  by  it  to  manage  special  departments  of  the  work.  For 
example,  the  management  of  the  Stock  Exchange  Building  is  in  the 
hands  of  the  Committee  on  Arrangements,  and  the  giving  out  of 
quotations  is  controlled  by  the  Committee  on  Commissions  and 
Quotations. 

It  has  frequently  been  suggested  by  outside  critics  that  the  Stock 
Exchange  should  be  incorporated  in  order  to  bring  it  under  a  larger 
degree  of  governmental  control.  This  suggestion  the  Exchange  has 
steadily  resisted.  The  Exchange  authorities  deny  that  the  public 
would  gain  from  such  incorporation  any  valuable  powers  of  control 
which  it  does  not  already  possess.  On  the  other  hand,  they  fear 
that  incorporation  would  tie  the  hands  of  the  Governing  Committee 
in  matters  of  discipline,  and  make  impossible  prompt  action  in  closing 


THE  SECURITY  MARKETS 


137 


the  Exchange  on  occasions  of  public  disturbance,  in  regulating  prices 
of  cornered  stocks,  and  in  similar  cases  of  emergency.  The  expe¬ 
rience  of  the  Chicago  Board  of  Trade,  which  is  incorporated,  does  not 
indicate  that  incorporation  would  be  likely  to  have  any  important 
effect  either  for  good  or  for  evil. 

The  membership  of  the  Exchange  includes  specialized  groups. — As 
was  noted  above,  membership  in  the  New  York  Stock  Exchange  is 
limited  to  1,100  members.  The  only  way,  therefore,  that  a  new  mem¬ 
ber  can  be  admitted  is  through  a  transfer  of  the  membership  of  some¬ 
one  else.  The  “seats”  are  regularly  bought  and  sold,  fluctuating  in 
value  with  the  volume  of  speculation.  During  the  war  boom,  seats 
in  the  New  York  Stock  Exchange  sold  as  high  as  $115,000.  Purchas¬ 
ing  a  seat,  however,  does  not  of  itself  entitle  one  to  a  membership,  as 
the  Committee  on  Memberships  scrutinizes  every  candidate’s  qualifica¬ 
tions  with  great  care,  and  individuals  whose  record  either  for  reliability 
or  for  financial  strength  is  unsatisfactory  are  quite  often  rejected. 

The  membership  is  made  up  chiefly  of  the  following  classes:  (1) 
partners  in  commission  brokerage  houses;  (2)  “two-dollar”  brokers; 
(3)  “specialists”;  (4)  dealers  in  odd  lots;  (5)  professional  speculators; 
and  (6)  inactive  members.  A  survey  of  the  work  of  these  classes  of 
members  will  serve  to  bring  out  most  of  the  essential  features  of  the 
organization  and  work  of  the  Exchange. 

1.  The  commission  brokerage  house  buys  and  sells  stocks  and  bonds 
as  the  agent  of  outside  investors  and  speculators. — It  is  always  unincorpo¬ 
rated,  sometimes  individually  owned,  more  often  a  partnership. 
A  large  brokerage  concern  usually  has  memberships  in  all  the  impor¬ 
tant  exchanges.  Officers  are  maintained  in  leading  cities  all  over 
the  country,  and  private  wire  connections  established  between  them. 

The  chief  asset  of  a  commission  house  is  its  list  of  customers. 
Its  chief  income  is  the  commission  it  obtains  for  executing  trades, 
either  upon  the  exchange  floor  or  elsewhere.  The  commission  for 
executing  trades  is  15  cents  per  share  for  stock  selling  from  $10  to  $125 
per  share;  7}  cents  per  share  below  that  figure  and  20  cents  per  share 
above,  and  $1.50  per  $1,000  for  bonds.  For  this  commission  the  broker 
attends  to  all  the  details  not  only  of  executing  the  trade  but  of  delivery, 
payment,  and  transfer  on  the  books  of  the  issuing  corporation,  and 
also  furnishes  its  customers  and  the  public  generally  with  a  large 
amount  of  service,  for  which  it  is  not  directly  paid.  Many  houses 
maintain  customers’  rooms  in  which  quotations  are  posted  on 
blackboards  as  fast  as  they  are  received  from  the  Exchange.  Financial 


138 


RISK  AND  RISK-BEARING 


journals  and  manuals  and  other  sources  of  information  are  kept 
available,  and  advice  is  freely  given  on  the  customer’s  investment  or 
speculative  problems.  In  addition  to  this,  the  commission  brokerage 
house  regularly  undertakes  the  responsibility  of  financing  its  cus¬ 
tomers’  purchases,  exacting  a  “margin”  of  from  5  to  40  per  cent  of 
the  amount,  and  furnishing  the  rest  of  the  capital  itself  or  borrowing 
it  from  banks. 

Facilities  are  also  offered  for  executing  what  is  known  as  a  “  short 
sale.” — This  is  a  sale  of  stock  which  the  customer  does  not  own  but 
which  is  borrowed  for  him  by  the  broker  for  delivery,  the  loan  being 
repaid  when  the  stock  is  bought  at  a  later  date.  The  financing  and 
executing  of  such  transactions  may  be  illustrated  by  the  following 
diagram: 


A  and  D  are  speculators,  and  B  and  C  their  respective  brokers. 
A  orders  B  to  “sell  short”  for  him  100  shares  of  Southern  Pacific 
stock,  posting  about  $1,000  as  margin.  B  sells  the  100  shares  at 
$98  each  to  C,  who  represents  D,  a  speculator  desirous  of  purchasing 
100  shares  of  Southern  Pacific.  D  usually  posts  with  C  $1,000  as 
margin.  Delivery  and  payment  must  be  made  the  next  day.  In 
order  to  make  delivery,  B  borrows  100  shares  of  Southern  Pacific 
from  F,  posting  with  F  the  full  $9,800  as  security,  and  delivers  the  stock 
to  C,  collecting  from  him  $9,800.  C  then  posts  the  stock  with  E,  a 
bank,  as  collateral  for  a  loan  of  say,  $8,000,  advancing  the  balance 
out  of  his  own  funds.  Usually  B  collects  from  F  interest  on  the  $9,800, 
which  is  posted  with  him  as  collateral  for  the  loan  of  the  100  shares  of 
stock.  D  pays  interest  to  C  on  his  unpaid  balance  of  $8,800  and  C, 
of  course,  pays  interest  to  E  on  the  $8,000  which  he  has  borrowed. 
Usually  C  and  F  pay  the  call  loan  rate,  while  D  pays  a  customary  rate 
which  does  not  fluctuate  as  often  as  the  call  loan  rate  but  averages 
somewhat  higher.  In  case  a  dividend  is  declared  on  the  stock  while 
the  short  trade  is  open,  both  D  and  F  are  entitled  to  receive  it.  Hence 
A  must  make  good  one  dividend,  the  company,  of  course,  paying  the 
other. 


THE  SECURITY  MARKETS 


139 


The  advantage  of  the  transaction  to  F  is  that  he  is  enabled,  through 
loaning  his  stock,  to  borrow  on  it  up  to  100  per  cent  of  its  face  value; 
whereas  through  a  bank  he  could  probably  not  borrow  more  than 
70  or  80  per  cent.  A  may  close  out  the  transaction  at  any  time  by 
ordering  B  to  purchase  stock  in  the  open  market  and  deliver  to  F 
in  repayment  of  the  loan.  D  also  may  close  out  the  trade  at  any 
time  by  ordering  C  to  sell  the  stock  in  the  open  market.  In  case  F 
desires  the  return  of  his  stock  before  A  wishes  to  purchase,  it  is  B’s 
business  to  borrow  the  stock  elsewhere.  In  case  the  stock  cannot  be 
borrowed,  B  must  “  cover  the  sale,”  i.e.,  buy  the  stock  in  for  A’s 
account.  Most  brokers  will  not  execute  orders  for  short  sales  except 
m  securities  which  have  a  large  floating  supply,  so  that  the  risk  of  being 
compelled  to  “cover”  in  this  way  is  small.  In  case  of  a  scarcity  of 
stock  for  loaning  purposes,  the  interest  rate  paid  by  the  lender  of 
stock  will  go  below  the  usual  call  rate.  Sometimes  the  lender  of 
stock  is  enabled  to  get  the  use  of  the  money  for  nothing,  in  which  case 
the  stock  is  said  to  loan  “flat”  and  occasionally  a  premium  is  paid  for 
use  of  the  stock  in  addition  to  the  waiver  of  interest.1 

In  practice,  of  course,  C  does  not  negotiate  a  separate  loan  at  the 
bank  for  every  margin  trade  his  customers  may  make.  What  he 
does  is  to  borrow  on  the  mass  of  securities  in  his  possession  as  much 
money  as  he  needs  to  take  care  of  his  customer’s  demands.  Most 
brokers  carry  their  customers  on  smaller  equities  than  do  the  banks, 
so  that  the  broker  has  to  advance  part  of  the  funds  on  his  own  capital. 
Some,  however,  pursue  the  opposite  policy,  requiring  margins  so  large 
that  they  can  secure  larger  loans  from  the  bank  than  they  make  to 
their  customers.  The  purpose  of  the  margins  is,  of  course,  to  protect 
the  brokers  against  adverse  fluctuations  in  the  price  of  the  stock. 
In  the  illustration  above,  if,  while  A  is  still  short,  the  price  of  Southern 
Pacific  advances,  B  must  have  some  protection  in  his  obligation  to 
return  the  stock  to  F  on  demand.  Even  if  he  is  not  required  to  return 
the  stock  he  may  be  called  upon  to  post  additional  money  for  F’s 
protection.  In  case  the  advance  in  prices  is  large,  A  will  be  called 
upon  to  post  additional  margin,  and  if  he  is  unable  or  unwilling  to  do 
so,  the  stock  will  be  bought  in  the  open  market  and  delivered  to  F  in 

1  For  instance,  the  following  quotations  were  published  on  April  7,  T921: 
“Crucible,  1-16  per  cent  premium;  American  Sugar,  B.R.T.,  D.&H.,  Maxwell, 
Penna.,  flat;  L.&N.,  2;  American  Smelting,  Anaconda,  Baldwin,  Bethlehem  B., 
General  Motors  new,  Alcohol,  M.P.,  Food  Products,  U.S.  Rubber,  U.S.  Steel,  6; 
Atchison,  B.&O.,  C.P.,  C.&O.,  St.  Paul,  R.I.,  Erie,  Marine  common,  Marine  pre¬ 
ferred,  N.H.,  Centra).  N.P.,  Reading,  S.P.,  Studebaker,  U.P.,  5  per  cent.” 


140 


RISK  AND  RISK-BEARING 


repayment  of  the  loan,  and  the  loss  charged  to  A’s  account.  In  case  a 
sudden  change  of  market  makes  it  impossible  for  the  broker  to  sell 
the  stock  at  a  price  which  protects  him,  or,  in  other  words,  in  case  the 
loss  is  greater  than  the  margin  A  has  posted,  B  has  a  valid  claim 
against  A  for  the  additional  loss.  D’s  margin  protects  C  against  a 
decline  in  price  just  as  A’s  margin  protects  B  against  advance. 

The  volume  of  exchange  trading  is  very  great. — The  way  in  which 
such  transactions  as  those  described  above  make  possible  an  enormous 
volume  of  trade  through  the  rapid  turnover  of  a  comparatively  small 
amount  of  stock  has  been  described  as  follows: 

The  process  is  very  simple,  once  you  get  it  clear.  We  take  a  simple 
case.  Suppose  A  has  1,000  shares  of  Bethlehem  Steel.  He  may  be  carry¬ 
ing  it  for  a  client.  Anyhow  he  has  it — the  actual  stock.  Let  us  suppose 
that  he  is  carrying  it  for  a  client,  and  has  hypothecated  it  along  with  other 
stocks  for  a  loan  at  his  bank.  Now  a  speculator  wishes  to  sell  Bethlehem 
Steel  for  a  fall,  that  is,  to  sell  it  short.  He  has  no  stock,  but  he  knows  he 
can  borrow  it.  Men  at  the  Bethlehem  Steel  post  are  bidding  for  it.  One 
who  shall  be  C  bids  150I  for  1,000  shares,  and  B  cries  “Sold!”  That  goes 
out  on  the  ticker  instantly — 1,000  shares  of  Bethlehem  Steel  sold  at  1503 
and  you  might  suppose  that  so  much  actual  property  had  changed  hands, 
like  real  estate.  But  the  seller,  remember,  had  no  Bethlehem  Steel  Stock  to 
sell.  He  may  never  have  owned  a  share  in  his  life.  But  all  the  same  he 
must  deliver  1,000  shares  to  C. 

After  the  close  of  the  day’s  trading  there  is  a  “loan  crowd,”  where  all 
active  stocks  are  borrowed  and  loaned.  B,  the  speculator,  shouts:  “I 
want  to  borrow  a  thousand  Bethlehem.”  And  now  A  appears.  He  has 
1,000  shares  of  stock  hypothecated  at  the  bank,  and  he  agrees  to  lend  it  to 
B.  They  exchange  memoranda.  So  now  A  gets  his  1,000  shares  of  Bethle¬ 
hem  Steel  back  from  the  bank  (either  by  paying  the  money  he  has  borrowed 
on  them  there  or  substituting  other  collateral  in  their  place),  and  delivers 
the  stock  to  B  in  exchange  for  a  certified  check  of  $150,500.  B  delivers 
this  borrowed  stock  to  C,  to  whom  he  sold  it,  and  receives  from  C  a  check 
of  $150,500  in  payment  for  it. 

The  actual  stock  is  now  in  possession  of  C,  who  hypothecates  it  at  his 
bank.  The  next  day  another  speculator,  who  shall  be  D,  in  like  manner  as 
B,  is  moved  to  sell  1,000  shares  of  Bethlehem  Steel  stock  for  a  fall.  He 
sells  it  to  E,  borrows  it  from  C  and  delivers  it  to  E.  Now  three  people  have 
title  to  1,000  shares  of  Bethlehem  Steel  stock,  namely,  (1)  A  who  had  it 
first  and  loaned  it  to  B,  (2)  C  who  bought  it  from  B,  and  (3)  E  who  bought 
it  from  D.  Actually  only  1,000  shares  of  real  stock  have  figured  in  these 
transactions,  but  2,000  more  have  been  bought  and  paid  for.  This  may  go 
on  and  on  so  long  as  nothing  unexpected  happens. 


THE  SECURITY  MARKETS 


141 

If  the  price  falls  the  speculators  who  have  sold  it  short  and  borrowed 
it  for  delivery  return  it  to  those  from  whom  *t  was  borrowed.  If  it  falls, 
for  example,  to  140^,  B  buys  1,000  shares  at  that  price,  for  $140,500, 
sends  the  stock  to  A  from  whom  he  borrowed  it,  and  gets  back  his  own 
original  $150,500.  The  difference  is  his  profit.  If  the  price  rises,  the  short 
sellers  buy  it  in  the  same  way  and  return  it  to  those  from  whom  they 
borrowed  it,  but  they  do  it  in  that  case  at  a  loss,  because  the  stock  they 
buy  is  worth  more  than  the  stock  they  borrowed. 

The  unexpected  does  sometimes  happen.  A  number  of  people  may  have 
been  lending  the  stock  over  and  over  to  short  sellers,  intending  all  at  once 
to  demand  the  return  of  it  in  a  concerted  manner.  The  speculators  are 
deceived  by  the  willingness  with  which  the  owners  lend  it  and  deduce  from 
that  that  the  supply  is  ample.  But  all  at  once  the  lenders  call  for  the  return 
of  the  stock  and  the  borrowers,  unless  they  can  find  other  owners  who  will 
lend,  are  compelled  to  buy  the  stock  in  the  open  market  at  a  loss. 

So  corners  are  contrived.  Speculators  are  beguiled  to  sell  what  they 
do  not  own,  because  they  think  it  will  fall  and  can  be  bought  cheaper  tomor¬ 
row,  and  the  stock  with  which  to  make  their  deliveries  is  loaned  to  them 
by  manipulators  who  may  know  all  the  time  approximately  how  much  real 
stock  there  is  in  the  floating  supply.  When  the  ratio  of  contracts  to  actual 
stock  is  very  high  they  call  suddenly  upon  the  borrowers  to  produce  it. 
As  it  cannot  be  produced,  the  borrowers  have  to  settle,  that  is,  they  have  to 
buy  at  any  price,  and  their  bidding  for  it  causes  wild  advances  in  the  price. 

In  a  stock  on  which  speculative  interest  is  centered  there  is,  of  course, 
a  great  deal  of  mere  “trading”  by  professional  members  of  the  Stock 
Exchange  who  seldom  receive  or  deliver  stocks  at  all.  They  buy  and 
sell  the  same  day,  their  purchases  canceling  their  sales.  One  who  buys 
1,000  Bethlehem  Steel  at  10  o’clock  and  sells  1,000  shares  at  3  o’clock  is 
“even.”  The  two  transactions  pair  themselves  off  at  the  Clearing  House 
afterward.  The  trader  merely  sends  a  record  of  what  he  has  done  to  the 
Clearing  House.  He  owes  nobody  any  stock;  nobody  owes  him  any  stock. 
But  there  is  a  difference  in  money  to  be  settled.  He  may  have  bought  from 
A  1,000  shares  in  the  morning  at  150^,  and  in  the  afternoon  he  may  have  sold 
1,000  shares  to  Z  at  151I.  He  has  made  a  profit  of  $1,000;  but  he  neither 
receives  stock  from  A  nor  delivers  stock  to  Z.  He  merely  attaches  to  his 
Clearing  House  sheet  a  draft  for  $1,000.  The  Clearing  House  deals  with 
A  and  Z.  A  has  sold  1 ,000  shares  of  stock  at  1 50I  for  which  he  will  receive 
$150,500  in  money.  Z  has  bought  1,000  shares  of  the  same  stock  at  151^, 
for  which  he  must  pay  $151,500.  The  difference  is  $1,000  and  that  is  the 
trader’s  profit.  A  sold  the  stock  to  the  trader  and  Z  bought  it  from  the 
trader,  but  it  is  Z  who  receives  it  from  A.  The  trader  was  in  the  middle, 
never  intending  either  to  receive  or  deliver  stock.  The  Clearing  House 
sends  him  $1,000  which  is  the  difference  between  what  A  gets  and  Z  pays 


142 


RISK  AND  RISK-BEARING 


for  the  i  ,000  shares  of  stock.  And  by  these  processes  mainly  is  it  possible 
for  Stock  Exchange  “transactions”  greatly  to  exceed  the  actual  amount 
of  a  given  stock  existing  in  Wall  Street.1 

Large  brokerage  houses  maintain  an  elaborate  system  of  private 
communication  between  their  offices  in  leading  cities. — These  are  called 
“wire  houses.”  The  following  is  an  excellent  description  of  this 
service : 

A  large  part  of  all  the  stock  bought  and  sold  in  the  Wall  Street  offices 
of  brokerage  firms  is  of  course  for  the  account  of  operators  who  live  in  New 
York.  But  in  addition  to  this  the  large  brokerage  concerns  have  a  remark¬ 
ably  expensive  telegraph  system  whereby  orders  are  gathered  from  far  distant 
points.  The  “wire  map”  of  any  one  of  a  half-dozen  or  so  of  the  large  houses 
looks  like  a  complete  railroad  guide  of  the  United  States.  One  particular 
firm  reaches  by  private  leased  duplex  wire  from  its  main  Wall  Street  office 
to  such  cities  as  Baltimore,  Washington,  Charlotte,  Charleston,  Atlanta, 
Savannah,  Augusta,  Jacksonville,  New  Orleans,  Memphis,  Chicago,  Cleve¬ 
land,  Cincinnati,  Omaha,  Colorado  Springs,  Denver,  Salt  Lake  City,  Butte, 
Spokane,  San  Francisco,  Pasadena,  Los  Angeles,  Coronado  Beach,  and 
San  Diego.  It  also  has  wire  connections  to  Boston,  Portland,  Montreal, 
Toronto,  Detroit,  Gary,  Indianapolis,  Louisville,  St.  Louis,  Kansas  City, 
Milwaukee,  St.  Paul,  and  Winnipeg.  This  particular  firm  has  six  branches 
in  the  state  of  California  alone.  These  wires  may  connect  with  branch 
offices  or  merely  with  correspondent  firms. 

The  relative  importance  of  this  outside  business  may  be  judged  from 
the  following  figures.  On  two  successive  days  in  the  summer  of  1919, 
75,000  and  60,000  shares  respectively  were  handled  by  branch  offices; 
while  38,000  and  46,000  shares  respectively  were  handled  by  the  main 
office  in  New  York.  The  extent  of  this  “outside”  participation  in  New 
York  Stock  Exchange  speculation  is,  of  course,  very  much  increased  in 
times  of  active  bull  markets,  such  as  prevailed  in  the  early  summer  and 
again  in  the  autumn  of  1919.3 

2.  “ Two-dollar  brokers”  are  exchange  members  who  specialize  in 
the  execution  of  trades  for  other  members. — They  are  so  called  because 
their  commission  at  the  time  the  name  arose  was  $2  per  100  shares  of 
stock  bought  or  sold.  (The  present  figure  is  $2.50.)  These  brokers 
are  of  two  classes.  Some  of  them  form  permanent  connections  with 
brokerage  houses,  doing  practically  all  of  their  floor  work.  Such  a 
connection  is  especially  valuable  to  a  small  house  whose  exchange 

1  Adapted  by  permission  from  “The  Phenomena  of  Phantom  Stocks,”  New 
York  Times  Annalist ,  August  2,  1915,  p.  127. 

'Adapted  by  permission  from  H.  G.  Moulton,  The  Financial  Organization  of 
Society ,  pp.  290-91.  (University  of  Chicago  Press,  1921.) 


THE  SECURITY  MARKETS 


143 


member  is  the  proprietor  of  the  business  or  a  senior  partner,  and  whose 
time  is  more  valuable  in  the  office  than  it  would  be  on  the  floor.  A 
large  house  finds  it,  as  a  rule,  more  economical  to  have  a  partner  who 
does  the  floor  work,  but  small  houses  often  do  not  have  enough  floor 
trading  to  occupy  the  entire  time  of  a  partner.  Other  two-dollar 
brokers  are  employed  by  the  floor  members  of  brokerage  houses  to 
assist  them  in  rush  periods,  or  at  times  when  they  have  orders  calling 
for  immediate  attention  in  different  parts  of  the  floor  at  the  same 
time.  This  is  particularly  likely  to  be  the  case  at  the  opening  of  the 
market,  when  the  trader’s  book  is  filled  with  an  accumulation  of 
overnight  orders. 

It  may  appear  that  there  is  an  unduly  wide  spread  between  the 
commission  of  $15,  which  the  brokerage  house  charges  its  customers 
for  buying  or  selling  100  shares,  and  the  $2.50,  which  it  pays  the 
“two-dollar  broker”  to  do  the  work  for  it.  It  must  be  remembered, 
however,  that  the  two-dollar  broker  has  no  responsibility  to  furnish 
information  to  customers,  maintains  no  selling  organization,  keeps  no 
books  except  his  list  of  open  orders  and  his  record  of  work  done, 
borrows  no  money  from  banks  or  stocks  from  other  brokers,  makes 
no  deliveries,  and,  in  general,  has  no  business  cares  and  responsibilities 
after  his  rather  short  day’s  work  is  done.  On  the  other  hand,  the 
accounting  work  alone  of  a  large  brokerage  house  is  a  task  requiring 
the  employment  of  many  clerks  and  bookkeepers,  while  the  annual 
cost  of  a  private  wire  between  two  important  trading  centers  may 
run  far  into  thousands  of  dollars.  Expensive  services  in  furnishing 
information  are  usually  provided.  It  is  these  outside  services,  rather 
than  the  actual  work  of  making  a  trade  on  the  floor  of  an  exchange, 
for  which  the  commission  house  receives  its  compensation. 

3.  The  “ specialist ”  makes  a  market  for  inactive  stocks. — The 
specialist  is  a  trader  and  broker  who  devotes  himself  solely  to  the 
execution  of  orders  and  stocks  traded  in  at  the  same  point  on  the 
floor,  sometimes  indeed  solely  to  the  issues  of  a  single  corporation. 
It  is  the  business  of  the  specialist  to  make  a  market  at  any  time  for 
the  security  in  which  he  specializes.  This  he  does  by  quoting  a  “bid 
and  asked”  price  upon  request.  If  few  other  dealers  are  interested 
in  the  security  in  which  he  specializes  and  there  is  little  speculative 
interest  in  it,  he  may  be  able  to  keep  the  market  for  himself  while 
quoting  a  bid  and  asked  price  a  considerable  distance  apart.  If  so, 
he  makes  of  course  a  correspondingly  large  profit  by  buying  at  the 
bid  and  selling  at  the  offered  price.  If  the  security  becomes  more 


144 


RISK  AND  RISK-BEARING 


active,  he  has  more  competition  and  must  quote  prices  closer  together 
in  order  to  make  trades,  thus  reducing  a  profit  on  a  single  transaction 
but  presumably  increasing  the  number  of  his  trades.  The  “  specialist  ” 
also  acts  as  a  “two-dollar  broker,”  handling  orders  for  other  brokers 
to  buy  and  sell  his  special  stocks.  In  this  case  he  gets  the  $2.50 
commission  just  as  the  regular  two-dollar  broker  would  get  it.  He  is 
of  course  not  allowed  to  act  both  as  a  broker  and  as  a  dealer  in  the 
same  transaction,  and  would  be  punished  by  a  heavy  fine  or  suspension 
if  caught  attempting  to  do  so. 

4.  The  odd  lot  dealer  handles  small  orders. — Another  very  interest¬ 
ing  branch  of  stock  exchange  business,  as  it  is  carried  on  in  New  York, 
is  the  work  of  the  odd  lot  dealer.  The  standard  unit  for  dealings  on 
the  New  York  Stock  Exchange  is,  as  previously  stated,  100  shares, 
and  only  trades  of  that  size,  or  of  some  multiple  of  100  shares,  are 
reported  on  the  ticker  or  closed  out  through  the  clearing  house. 
There  is  however  a  very  large  volume  of  business  in  less  than  100 
share  lots — some  estimates  of  it  run  as  high  as  20  per  cent  of  the  total 
trade.  Almost  any  brokerage  house  will  accept  orders  for  as  few  as 
25  shares  for  margin  accounts  and  smaller  lots  for  cash  sale  or  purchase, 
and  some  houses  handle  as  few  as  10  shares  in  a  single  order  on  margin 
account.  In  executing  these  trades,  resort  is  nearly  always  had  by 
the  broker  to  representatives  of  a  few  large  houses  which  specialize 
in  the  odd  lot  business.  These  houses  buy  and  sell  on  their  own 
account,  making  their  income  out  of  profits  on  the  trade,  not  out  of 
commissions.  The  customer,  of  course,  pays  the  usual  commission, 
but  this  goes  to  the  house  which  represents  him,  not  to  the  odd  lot 
house.  The  most  frequent  way  in  which  such  orders  are  executed  is 
to  hold  them  until  the  next  trade  in  the  round  lot  market,  immediately 
after  which  the  odd  lot  man  will  sell  at  one-eighth  or  one-quarter 
point1  above,  or  buy  one-eighth  or  one-fourth  below  the  price  recorded. 
This  gives  him  a  profit  of  one-quarter  or  one-half  point  if  he  is  able 
to  make  both  a  purchase  and  a  sale  before  the  “round  lot”  price 
changes. 

Another  method  which  avoids  the  delay  incident  to  waiting  for  a 
sale  is  for  the  odd  lot  house  to  buy  at  the  bid  price  and  sell  at  the 
offered  price  (or  one-eighth  away  in  the  case  of  inactive  stocks).  In 
this  case  the  odd  lot  dealer  makes  his  profit  out  of  the  spread  between 
the  bid  and  the  asked  price,  just  as  does  the  specialist. 

1 A  “point”  is  one  dollar  per  share  in  stock  quotations,  or  ten  dollars  per 
thousand  dollars  face  value  in  bond  quotations. 


THE  SECURITY  MARKETS 


145 


In  order  to  make  his  deliveries,  the  odd  lot  man  is  frequently 
obliged  to  buy  or  borrow  100  share  lots  and  split  them  up  into  frac¬ 
tional  lots,  remaining  “long”  of  the  unused  balance  if  he  buys,  or 
“short”  of  the  amount  sold  if  he  borrows'  This  leaves  him,  of  course, 
exposed  to  the  risk  of  market  fluctuations,  but  he  is  able  to  keep  this 
risk  at  a  minimum  by  buying  part  of  his  stocks  and  borrowing  part 
of  them,  so  that  in  case  of  a  market  change  he  will  make  about  as 
much  on  the  stocks  in  the  one  group  as  he  loses  on  the  stocks  in  the 
other. 

The  following  is  a  description  of  the  work  of  the  odd  lot  dealer: 

The  stocks  traded  in  on  the  Exchange  are  divided  by  the  “Odd  Lot” 
dealer,  into  two  classes,  which  are  known  as  “eighth  stocks”  and  “quarter 
stocks.”  An  “ odd  lot ”  order  in  an  “eighth  stock ”  is  executed  at  one-eighth 
point  from  the  next  “full  lot”  sale,  or  if  the  client  so  desires,  at  the  bid  or 
offered  price.  Orders  in  “quarter  stocks”  are  executed  at  one  quarter 
point  from  the  next  full  lot  sale,  or  one-eighth  point  from  the  bid  or  offer. 
A  large  majority  of  the  stocks  are  “eighth  stocks.”  The  “quarter  stocks” 
are  either  inactive  or  the  price  fluctuations  in  them  are  at  such  wide  figures 
that  trading  on  so  narrow  a  margin  for  profit  as  one-eighth  of  one  percent 
would  be  impracticable  to  the  odd  lot  dealer,  and  would  not  permit  him 
to  give  the  free  market  in  every  stock  on  the  list  whether  active  or  inactive 
that  now  exists  for  the  trader  in  odd  lots. 

The  firms  which  deal  exclusively  in  odd  lots  are  represented  by  as  mani¬ 
as  twenty-five  or  more  members  on  the  New  York  Stock  Exchange.  Each 
one  of  these  representatives  is  located  in  his  particular  place  or  station  on 
the  Exchange  floor  and  confines  his  activities  solely  to  the  execution  of  the 
odd  lot  orders  in  the  group  of  stocks  assigned  to  him. 

The  individual  desiring  to  buy  or  sell  an  odd  lot  gives  an  order  at  the 
office  of  a  Stock  Exchange  house  or  to  one  of  its  branch  offices  or  out-of-town 
correspondents  with  whom  he  has  an  account  or  wishes  to  open  one.  The 
New  York  Office  immediately  upon  receipt  telephones  the  order  to  its  clerk 
on  the  floor  of  the  Stock  Exchange  who  writes  it  on  an  order  slip  and  hands 
it  to  a  Stock  Exchange  employee  in  charge  of  the  pneumatic  tubes  at  his 
booth.  It  is  then  sent  through  a  tube  to  the  tube  station  at  the  post  at 
which  the  particular  stock  is  traded  in,  where  it  is  removed  from  the  carrier 
by  another  Stock  Exchange  employee  and  by  him  handed  to  the  odd  lot 
dealer  or  placed  on  the  odd  lot  dealer’s  special  clip  at  his  post.  If  it  is  a 
limited  order,  the  odd  lot  dealer  enters  it  in  his  book;  if  it  is  a  market 
order  he  executes  it,  basing  the  price  on  the  first  sale  of  a  full  lot  that  takes 
place  after  he  receives  the  order.  He  then  hands  the  report  of  the  execution 
of  the  order  to  the  tube  employee  who  sends  it  through  another  tube  back 
to  the  original  tube  station;  here  it  is  handed  to  the  telephone  clerk  who 
telephones  it  to  the  office. 


146 


RISK  AND  RISK-BEARING 


Market  orders :  An  odd  lot  market  order  is  an  order  to  buy  or  sell  a 
stated  number  of  shares  from  1  to  99  at  f  (or  |)  away  from  the  price  of  the 
next  sale  of  a  full  lot  taking  place  after  receipt  of  the  order  by  the  odd  lot 
dealer.  Market  orders  received  before  the  opening  of  the  market  are 
executed  at  |  (or  £)  from  the  opening  price.  It  sometimes  happens,  how¬ 
ever,  especially  when  important  news  about  a  stock  has  come  out  over  night 
that  there  will  be  a  wide,  or  as  it  is  sometimes  called  “a  split  opening,” 
when  sales  at  different  parts  of  the  crowd  occur  simultaneously  at  different 
prices.  For  example:  U.S  Steel  might  have  an  excited  opening,  sales  of 
ten  thousand  shares  taking  place  immediately  upon  the  ringing  of  the  open¬ 
ing  gong  at  from  80  to  81  and  the  ticker  would  report  “U.S.  Steel  10,000, 
80  to  81.”  A  reasonable  opening  price  between  these  prices  would  have  to 
be  decided  on.  In  this  case  it  would  very  likely  be  that  the  odd  lot  dealer 
would  buy  at  8of  or  sell  at  8of . 

Limited  orders:  An  odd  lot  limited  order  is  an  order  to  buy  or  sell  a 
stated  number  of  shares  from  1  to  99  at  a  stated  price.  For  example:  An 
order  is  given  “Buy  10  Reading  at  69.”  That  this  order  may  be  executed 
Reading  must  sell  at  68|  or  less.  If  the  first  sale  after  receipt  of  this  limited 
order  permits  of  its  execution,  the  limit  is  ignored  and  the  order  considered 
a  market  order.  Should  the  first  sale  be  68j  the  order  would  be  executed 
at  68f.  A  limit  is  also  ignored  on  a  limited  order  if  the  opening  sale  any 
morning  permits  of  its  execution  while  the  order  is  in  force.  A  limited  order 
must  be  executed  at  its  limit,  however,  when  the  next  sale  after  it  is  received 
does  not  permit  of  its  execution.  For  example.  An  order  is  given  to  “ Buy 
10  Reading  at  69.”  If  the  first  sale  after  receipt  of  the  order  is  695  and  the 
next  sale  685  the  order  is  executed  at  69.  In  this  case  the  odd  lot  trader 
secures  exactly  the  price  he  would  have  secured  had  this  order  been  for 
100  shares,  because  his  broker  would  have  been  bidding  69  and  the  100 
shares  would  have  been  sold  to  him  at  69  on  his  bid  before  the  stock  could 
sell  at  685. 

Stop  orders:  A  stop  order  is  an  order  to  buy  or  sell  a  stated  number  of 
shares  at  the  market  after  a  fixed  price  is  reached.  An  odd  lot  stop  order 
is  executed  at  ^  (or  \ )  from  the  first  sale  of  a  full  lot  which  makes  the  stop 
order  operative.  For  example  u  Sell  10  Reading  69  Stop”  If  Reading 
sells  at  695  and  then  at  69  the  order  is  executed  at  685  but  if  the  sale  after 
695  is  685  then  the  stop  order  is  executed  at  68f . 

Orders  to  buy  or  sell  at  the  close:  An  order  may  be  given  to  buy  or  sell 
an  odd  lot  “at  the  close.”  The  execution  of  these  orders  is  always  based 
on  the  closing  bid  and  offer  and  not  on  the  last  sale  of  the  day.  It  would 
be  impracticable  for  the  odd  lot  dealer  to  trade  on  the  last  sale,  as  the  last 
sale  might  occur  as  early  as  2:30  p.m.  and  this  sale,  for  example,  might  have 
been  at  69  and  the  close  68-685  or  695-70.  In  justice  to  all  concerned 
therefore  an  order  reading  “At  the  close”  must  mean,  at  the  closing  bid 
or  offer  (or  §  away). 


THE  SECURITY  MARKETS 


147 


These  methods  for  conducting  trading  in  Odd  Lots,  have  been  in  general 
use  on  the  New  York  Stock  Exchange  for  the  past  forty  years.1 

5.  Floor  traders  speculate  on  their  own  account. — Professional 
speculators  are  not  always  members  of  the  Exchange,  but  many  of 
them  do  find  it  advantageous  to  purchase  memberships  either  in 
order  to  make  their  own  trades  on  the  floor  of  the  Exchange  or  in 
order  to  secure  the  advantage  of  the  lower  rate  of  commission  which 
is  charged  by  members  executing  trades  for  one  another.  Those  who 
trade  for  themselves  are  usually  what  are  known  as  “scalpers,”  i.e., 
speculators  who  trade  for  small  profits — an  eighth  to  a  half  “point” 
on  a  trade,  and  close  out  their  trades  quickly  if  the  price  goes  against 
them.  In  this  sort  of  speculation,  of  course,  the  trader  is  governed 
not  by  considerations  of  the  investment  value  of  the  securities  in 
which  he  trades  but  by  his  judgment  of  the  conditions  which  affect 
the  market  of  the  immediate  future.  Consideration  will  be  given 
to  these  “technical  conditions,”  as  they  are  called,  in  chapter  ix. 

6.  Inactive  members  are  numerous. — These  comprise  the  office 
members  of  certain  brokerage  houses,  who  seldom  appear  on  the 
floor,  a  few  large  professional  operators  who  own  memberships  for 
the  sake  of  the  reduction  in  commissions  which  it  gives  them,  and  a 
great  many  representatives  of  prominent  investment  institutions, 
who  make  little  direct  use  of  their  memberships  but  desire  to  have 
some  voice  in  the  management  of  the  exchange  or  find  some  advertis¬ 
ing  value  in  their  connection  with  it. 

The  “ Curb ”  Market  specializes  in  newer  stocks. — Other  exchanges 
in  the  United  States  need  little  description,  as  they  are  all  much  smaller 
than  the  New  York  Stock  Exchange,  and  present  no  points  of  differ¬ 
ence  which  are  of  interest.  Until  recently  a  noteworthy  exception 
to  this  statement  was  found  in  the  New  York  Curb  Market,  the  great 
market  place  for  unlisted  securities.  This  was  an  informal  gathering 
of  brokers  who  met  in  the  open  air  on  Broad  Street,  in  New  York 
City,  and  carried  on  an  active  trade,  largely  in  mining  stocks  and  the 
stocks  of  new  corporations.  Orders  were  transmitted  by  signals  from 
adjacent  windows,  and  quotations  were  recorded  only  by  newspaper 
reporters  who  collected  them  from  various  brokerage  houses  specializ¬ 
ing  in  the  Curb  trade. 

At  first  the  Curb  trade  was  entirely  disorganized,  anyone  being 
free  to  trade  or  refuse  to  trade  with  anyone  he  pleased.  An  organiza- 

1  Adapted  by  permission  from  a  pamphlet  issued  by  Carlisle,  Mellick,  and  Com¬ 
pany,  New  York. 


148 


RISK  AND  RISK-BEARING 


tion  was  formed  however  for  the  purpose  of  introducing  some  system 
and  responsibility.  This  organization  grew  more  and  more  powerful 
till  in  1921  it  emerged  as  a  full-grown  stock  exchange,  housed  in  a 
splendid  building,  with  ticker  service,  listing  rules,  and  with  the 
opportunity  of  trading  on  the  floor  restricted  to  members.  A  small 
remnant  of  the  old  group  remained  in  Broad  Street  as  the  “outside 
Curb,”  but  this  market  is  at  present  of  slight  importance. 

The  “inside”  or  regular  Curb  is  made  up  chiefly  of  partners  of 
members  of  New  York  Stock  Exchange  firms  and  constitutes  an 
important  feature  of  our  market  machinery.  In  theory  its  listing 
requirements  are  quite  as  rigid  as  those  of  the  New  York  Stock 
Exchange,  but  the  regulations  apparently  are  not  enforced  in  the  same 
spirit,  as  a  considerable  trade  is  reported  in  securities  of  corporations 
which  refuse  to  publish  income  statements  or  other  information  deemed 
essential  by  the  older  organization.  Indeed  it  is  difficult  to  see  the 
advantage  of  maintaining  the  two  organizations  were  it  not  for  this 
sort  of  specialization  in  the  class  of  securities  traded  in.  The  Curb 
serves  as  a  seasoning  place  where  a  market  can  be  maintained  by 
stock  exchange  members  without  even  the  qualified  indorsement 
of  the  securities  which  is  implied  in  listing  them  on  the  larger 
Exchange. 

The  Consolidated  Stock  Exchange  is  a  rival  New  York  organization. — 
It  deals  chiefly  in  the  same  securities  that  are  traded  on  the  New  York 
Exchange.  It  has  an  entirely  separate  membership,  consisting  chiefly, 
though  not  entirely,  of  smaller  commission  houses  and  private  floor 
traders.  The  unit  of  trading  is  ten  shares,  and  a  much  larger  propor¬ 
tion  of  the  trade  is  professional  “scalping”  than  is  the  case  in  the 
“Big  Exchange.”  For  the  most  part  the  prices  tend  to  follow  the 
quotations  on  the  New  York  Exchange.  During  the  past  year  (1921- 
22)  the  Consolidated  Stock  Exchange  has  suffered  a  considerable  loss 
of  reputation  on  account  of  a  number  of  failures  in  its  membership. 
It  does  not  appear,  however  that  there  is  any  inherent  weakness  in 
the  organization  which  accounts  for  the  higher  percentage  of  failures 
among  the  Consolidated  as  compared  with  the  New  York  Stock 
Exchange  membership. 

Other  American  stock  exchanges  are  much  smaller  than  the  New 
York  Exchange. — The  American  stock  exchanges  outside  New  York 
City  are  chiefly  of  local  importance.  In  most  of  them  the  securities 
of  local  public  utilities  and  industrials  are  apt  to  be  absorbed  by  the 


THE  SECURITY  MARKETS 


149 


New  York  Stock  Exchange  as  soon  as  they  become  of  national 
interest.1 

There  is  also  a  considerable  amount  of  specialization  by  industries, 
which  is  only  partly  accounted  for  by  location.  Thus,  the  Boston 
Exchange  is  the  great  market  for  copper  stocks,  though  a  dozen  of 
the  leaders  are  active  in  New  York;  automobile  stocks  are  heavily 
traded  in  Detroit;  gold-mining  stocks  in  San  Francisco  and  Denver; 
and  public  utilities  in  Philadelphia. 

In  general,  the  methods  used  in  the  smaller  exchanges  are  less 
formal,  and  the  requirements  both  for  membership  and  for  listing 
securities  less  exacting  than  is  the  case  in  the  New  York  Stock 
Exchange.  The  relative  importance  of  the  outside  exchanges  and 
the  New  York  Exchange  may  be  judged  from  the  fact  that  the  New 
York  Exchange  has  sometimes  handled  more  stock  in  a  single  day 
than  the  Chicago  Exchange  handled  in  the  entire  year. 

There  is  a  large  trade  in  securities  outside  the  exchanges. — Many 
stocks  of  well-known  corporations  are  not  listed  on  any  exchange, 
and  many  stocks  which  are  listed  rarely  appear  in  the  published 
quotation  lists,  for  the  reason  that  no  trades  are  executed  in  them. 
This  indicates  a  lack  of  public  interest  in  the  security,  but  does  not 
prove  anything  with  regard  to  its  merits.  Often  the  inactivity  is 
due  to  the  fact  that  nearly  all  the  issue  is  closely  held  by  interests 
affiliated  with  the  management,  or  by  investors  who  are  not  active 
speculators  and  cannot  be  induced  to  dispose  of  their  holdings  except 
by  bidding  up  the  price  to  an  unreasonable  level.  On  the  other  hand, 
the  lack  of  interest  may  be  due  to  the  fact  that  the  corporation  in 
question  has  been  so  thoroughly  discredited  that  no  one  cares  to  buy 
its  stock.  Again,  it  may  be  because  the  corporation  has  done  no 
public  financing,  and  no  broker  has  ever  taken  the  trouble  to  work 
up  an  interest  in  its  securities,  so  that  few  people’s  attention  is  called 
to  their  investment  or  speculative  possibilities. 

Whenever  a  stock  or  bond  becomes  inactive,  the  bid  and  asked 
prices  draw  apart,  so  that  it  becomes  difficult  to  buy  without  running 
up  the  price  and  equally  difficult  to  sell  without  breaking  it.  In 
such  cases  the  exchange  method  of  dealing  is  not  advantageous. 
Exchange  trading  really  is  based  on  the  presumption  that,  whatever 

1  This  is  apparently  less  likely  to  happen  in  the  case  of  public  utilities.  Peoples 
Gas  of  Chicago,  Pacific  Gas  and  Electric  of  San  Francisco,  and  Columbia  Gas  and 
Electric  of  Cincinnati  are  the  only  outside  local  utilities  which  are  at  all  active  in 
the  New  York  market. 


RISK  AND  RISK-BEARING 


150 

the  price  may  be,  a  slight  decline  will  bring  in  new  buying  from 
brokers  who  are  present  and  immediately  aware  of  the  change,  and 
that  a  slight  rise  will  bring  forth  selling.  Its  foundation  principle  is 
continuity.  If  only  one  or  two  brokers  are  interested  in  a  security 
at  any  reasonable  price,  it  is  obvious  that  public  bids  and  offers  on 
the  exchange  do  not  constitute  an  efficient  method  of  establishing 
sales  at  a  price  corresponding  to  the  known  facts  about  the  security. 
Some  device  is  needed  for  hunting  up  a  second  party  to  accept  a 
given  bid  or  offer.  In  such  cases  the  most  important  marketing 
agency  is  the  so  called  “over-the-counter”  market.1 

Over-the-counter  trading  means  chiefly  trading  by  telephone  and 
telegraph.  Houses  handling  this  kind  of  business  usually  cater  more 
to  the  investment  than  to  the  speculative  trade,  and  for  this  reason 
bonds  are  handled  more  than  stocks. 

The  trader’s  equipment  consists  of  a  set  of  telephones  in  the  quiet¬ 
est  room  available,  some  financial  manuals,  a  card  index  of  securities 
showing  the  latest  bids  and  offers,  a  battery  of  clerical  assistants,  a 
quick  wit,  and  a  reputation  for  fair  dealing.  When  the  house  receives 
an  order  for  a  bond  or  share  of  stock  which  it  does  not  itself  have  for 
sale,  inquiries  are  put  out.  Sometimes  a  certain  house  is  known  to 
specialize  in  securities  of  the  particular  corporation  in  question.  If 
the  security  was  originally  underwritten,  the  house  of  first  purchase 
will  usually  “maintain  the  market”  by  standing  ready  to  buy  or  sell 
at  a  narrow  spread  of  bid  and  offered  price,  and  will  have  on  file  lists 
of  present  holders  who  are  the  most  likely  prospects  for  either  sales 
or  purchases.  A  house  may  specialize  in  the  securities  of  a  corpora¬ 
tion  for  which  it  has  done  no  underwriting,  however,  particularly  if 
it  handles  the  securities  of  affiliated  interests.  If  no  house  is  known 
to  specialize  in  the  securities  of  the  particular  corporation,  it  is  often 
possible  for  the  trader  to  make  a  deal  through  a  house  which  specializes 
in  the  securities  of  the  whole  industry  in  question.2  Again,  as  noted 
above,  trade  in  certain  classes  of  stocks  and  bonds  is  centralized  in 
certain  cities,  and  an  order  for  such  securities  will  most  likely  be 
telegraphed  at  once  to  some  house  in  that  city.  In  the  absence  of  a 
specialized  center,  inquiries  will  be  scattered  more  or  less  broadcast,' 
and,  in  case  of  an  order  of  large  size,  rapidly  find  their  way  around  the 
United  States,  Canada,  and  Europe,  each  trader  passing  on  the  inquiry 

1  In  Chicago  the  over-the-counter  market  is  called  the  “curb.” 

3  See  for  examples  the  advertising  columns  of  the  Wall  Street  Journal  and  of 
the  New  York  Times  Annalist. 


THE  SECURITY  MARKETS 


'Si 

to  someone  else.  The  inquiry  sometimes  comes  back  to  the  original 
inquirer  from  various  directions.  This  wandering  and  redoubling 
may  give  the  appearance  of  a  much  more  active  interest  than  really 
exists.  Sometimes  resort  is  had  to  advertising,  a  few  houses  regularly 
publishing  lists  of  securities  which  they  desire  to  buy  or  sell,  sometimes 
with,  and  sometimes  without,  quotations.  In  the  case  of  an  inactive 
security,  it  is  not  unusual  for  a  considerable  difference  to  appear  in 
simultaneous  bids  and  offers  published  by  competing  houses. 

Independent  brokers  also  make  a  business  of  making  the  rounds 
of  the  larger  houses  in  New  York,  getting  lists  of  securities  wanted,  and 
bringing  the  trader  in  touch  with  others  who  can  supply  his  needs. 
Some  of  these  brokers  take  one  side  of  the  trade  themselves,  and  may 
make  a  considerable  margin  by  buying  in  one  office  at  the  offering 
price  and  selling  in  another  at  the  bid  price.  To  an  increasing  extent, 
however,  the  business  is  done  by  regularly  organized  “street  broker¬ 
age”  houses,  which  charge  commissions  for  bringing  buyers  and 
sellers  together.  It  is  of  course  illegal  to  take  both  a  commission 
and  a  profit  on  the  same  trade. 

To  a  large  extent  the  brokerage  work  of  a  large  investment  house 
is  done  for  no  commission  or  a  nominal  one,  to  retain  the  good  will  of 
customers  with  whom  new  issues  may  be  placed.  Often,  indeed, 
the  placing  of  a  new  issue  requires  that  assistance  be  given  the  customer 
to  get  rid  of  his  present  holdings  in  order  to  invest  the  proceeds  in  the 
new  issue.  The  underwriter’s  profit  on  the  new  issues  makes  it  worth 
while  to  do  a  great  deal  of  this  brokerage  work  as  an  accommodation 
for  customers,  in  order  to  keep  the  market  for  new  securities  alive. 

II.  THE  MARKET  FOR  NEW  SECURITIES 

The  marketing  of  new  issues  of  corporation  bonds  and  stocks  is  a 
business  of  entirely  different  character  from  the  business  of  bringing 
together  buyers  and  sellers  of  securities  already  outstanding.  In  the 
latter  case,  no  one  is  greatly  concerned  in  facilitating  the  trade  except 
two  investors,  one  seeking  to  buy  and  the  other  to  sell.  If  the  issuing 
corporation  has  any  interest  in  the  trade  it  is  indirect,  as  the  quotations 
for  its  securities  may  affect  its  credit  at  the  banks,  or  influence  the 
market  for  other  securities  it  may  have  to  offer  in  the  future.  Conse¬ 
quently,  the  compensation  of  the  broker  or  other  middleman  dealing 
in  old  securities  must  come  in  one  way  or  another  out  of  the  difference 
between  the  prices  at  which  one  investor  is  willing  to  sell  and  another 
is  willing  to  buy  at  the  same  time.  This  margin,  in  the  case  of  securi- 


152 


RISK  AND  RISK-BEARING 


ties  of  established  merit,  is  usually  rather  narrow,  so  that  the  middle¬ 
man  cannot  afford  to  go  into  the  market  and  use  the  arts  of  salesman¬ 
ship  to  drum  up  purchasers.  His  function  approaches  that  of  a  real 
middleman,  that  is,  a  connecting  link  between  two  individuals  who 
have  a  real  interest  in  getting  in  touch  with  one  another. 

On  the  other  hand,  corporations  in  need  of  capital  are  willing,  or 
can  be  forced,  to  pay  for  capital  amounts  largely  in  excess  of  what  the 
average  investor  can  secure  for  his  relatively  small  units  of  capital 
without  the  aid  of  the  middleman.  The  margin  between  the  most  the 
public  will  pay  and  the  least  the  corporation  can  afford  to  take,  rather 
than  fail  to  market  its  securities,  is  a  large  one,  hence  the  compensa¬ 
tion  of  the  banker  who  effects  the  sale  can  be  made  much  larger  than 
is  possible  in  brokerage  in  old  securities.  Moreover,  new  securities 
usually  require  some  active  effort  to  interest  investors  in  their  merits, 
in  part  because  they  lack  the  reputation  which  comes  from  a  satis¬ 
factory  record  of  interest  or  dividend  payments,  and  in  part  simply 
because  they  are  unfamiliar  and  if  not  advertised  would  be  likely  to 
remain  unnoticed.  This  makes  the  services  of  specialized  selling 
agents  necessary. 

The  selling  of  new  securities  comprises  several  quite  different  kinds 
of  marketing. — High-grade  securities  are  seldom  sold  without  pro¬ 
fessional  aid,  except  where  stock  is  sold  through  the  issuance  of 
“rights”  to  subscribe  at  a  low  price  to  holders  of  stock  already  out¬ 
standing,  and  even  in  this  case  the  guaranty  of  a  financial  institu¬ 
tion  is  sometimes  secured  before  the  issue  is  offered.  Low-grade 
securities,  on  the  other  hand,  are  frequently  marketed  direct  by  the 
issuers,  less  often  through  the  agency  of  a  bank,  broker,  or  bond-dealer.1 

The  chief  institution  concerned  in  the  marketing  of  new  securities 
of  a  conservative  type  is  the  investment  bank,  commonly  known  as 
the  bond  house.  Typically,  this  is  a  highly  specialized  institution, 
though  of  recent  years  a  great  deal  of  the  business  has  been  taken  over 
by  bond  departments  of  large  city  banks,  and  there  is  also  some 
tendency  to  combine  the  business  with  brokerage  in  miscellaneous 
stocks. 

1  By  high-grade  securities  are  meant  the  prior  lien  bond  of  solvent  corporations 
with  a  fair  earning  record  extending  over  a  period  of  some  years  and  not  engaged 
in  a  highly  speculative  line  of  business,  the  junior  bonds  and  preferred  stocks  of  the 
stronger  members  of  this  group,  and  the  common  stocks  of  a  few  of  the  very 
strongest.  It  should  not  be  overlooked  that  this  classification  has  reference  only 
to  new  securities.  Old  securities  present  such  a  regular  gradation  of  degrees  of 
risk  from  the  safest  to  the  most  speculative  that  a  classification  into  “high  grade” 
and  “low  grade”  has  little  or  no  usefulness. 


THE  SECURITY  MARKETS 


153 


Investment  houses  are  of  three  principal  types:  first,  the  large 
houses  which  deal  directly  with  corporations,  taking  over  whole 
issues  or  arranging  syndicates  to  divide  the  responsibility;  second, 
the  distributing  houses,  which  do  little  or  no  large  purchasing  but 
accept  allotments  from  houses  of  first  purchase  and  distribute  them 
to  their  customers;  third,  houses  organized  in  affiliation  with  indi¬ 
vidual  corporations  (usually  in  the  public  utility  field)  to  aid  in  the 
distribution  of  their  securities.1 

Analysis  of  the  merits  of  a  proposed  issue  of  corporation  securities 
and  determination  of  the  price  at  which  it  should  be  offered  to  the 
public,  if  it  is  deemed  to  be  worth  floating  at  all,  is  highly  expert 
work.  It  includes  an  analysis  of  the  corporation’s  record  of  earnings 
and  of  its  balance  sheet,  an  appraisal  of  the  property,  usually  by  a 
firm  of  engineers,  an  audit  of  the  books  by  an  independent  firm  of 
public  accountants,  a  survey  of  the  state  of  the  industry  in  which  the 
firm  is  engaged,  and  a  study  of  the  outlook  for  the  security  market. 
This  work,  however,  has  to  be  done  only  by  the  house  of  first  purchase. 
The  distributing  houses  content  themselves,  as  a  rule,  with  the  results 
of  the  investigation  made  by  the  purchasing  house  and  apply  for  as 
many  bonds  as  they  think  they  can  dispose  of,  or,  perhaps  more  often, 
accept  the  quota  which  is  allotted  them.  The  retail  price  is  fixed  by 
the  original  purchasers,  or  by  the  management  of  the  syndicate  if  it 
is  a  joint  undertaking,  and  no  house  is  allowed  to  sell  its  quota  below 
this  figure.  The  weaker  distributing  houses  are  dependent  on  the 
good  will  of  the  larger  houses  to  secure  their  quotas,  and  can  hardly 
refuse  to  accept  the  responsibility  for  the  share  which  is  given  them.2 

The  houses  which  distribute  securities  direct  to  investors  number 
several  thousand  in  the  United  States  alone.  The  process  of  distribut¬ 
ing  an  issue  has  been  described  by  one  writer  as  follows: 

When  an  issue  of  securities  is  ready  for  distribution,  it  is  necessary  to 
attract  the  attention  of  potential  investors.  This  is  customarily  done  by 

1  For  example,  the  Utilities  Securities  Corporation’s  chief  business  is  the  mak¬ 
ing  and  finding  of  a  market  for  the  securities  of  a  group  of  ijiidwestern  public  utili¬ 
ties  controlled  by  Samuel  Insull;  the  Electric  Bond  and  Share  Company  distributes 
securities  of  corporations  affiliated  with  the  General  Electric  Company;  Henry  A. 
Doherty  and  Company  distributes  the  numerous  issues  of  the  Cities  Service  Com¬ 
pany  and  its  subsidiaries. 

2  Cases  are  not  unknown  where  distributing  houses  have  accepted  quotas  of 
undesirable  issues  rather  than  risk  the  loss  of  good  will  of  the  house  responsible  for 
the  securities’  distribution,  but  insisted  on  the  listing  of  the  securities  on  a  stock 
exchange  so  they  might  have  a  chance  to  get  rid  of  their  quotas  through  an  imper¬ 
sonal  market  and  not  have  to  load  up  their  own  customers  with  them. 


*54 


RISK  AND  RISK-BEARING 


means  of  a  public  announcement,  which  formally  calls  attention  to  the 
amount  of  the  issue,  the  terms,  and  the  date  by  which  subscriptions  must 
be  in.  In  many  cases  a  great  deal  of  general  advertising  has  been  quietly 
done  before  the  public  announcement  is  made;  indeed,  the  securities  may 
all  have  been  subscribed  for  in  advance,  in  which  case  the  public  announce¬ 
ment  might  be  regarded  as  superfluous,  except  that  it  affords  an  opportunity 
to  call  attention  to  the  significant  fact  that  the  bonds  have  already  been 
disposed  of,  thereby  adding  to  the  prestige  of  the  house  or  syndicate.  The 
public  announcement  is  aimed  at  investors  en  masse ,  and  it  is  effective  in 
proportion  to  the  attractiveness  of  the  particular  issue  and  the  condition  of 
the  investment  market. 

The  subscribers  include,  as  already  noted,  the  houses  which  have 
participated  in  the  syndicate,  other  bond  houses,  dealers  and  brokers,  and 
a  number  of  closely  associated  financial  institutions.  One  writer  has  listed 
the  following  among  these  associated  institutions: 

“i.  An  insurance  company  and  its  directors,  who,  if  rich  men,  will 
probably  buy  for  their  own  account  some  portion  of  a  bond  issue  that  their 
company  has  taken. 

“2.  A  firm  of  bankers  or  a  bank  in  a  smaller  city  that  supplies  a  local 
investment  demand. 

“3.  A  European  group  or  syndicate  that  acts  as  a  secondary  distributor 
or  buys  securities  against  which  it  issues  its  own  debentures,  as  in  the  case 
of  the  Scotch  trust  companies  and  the  investment  associations  of  Holland. 

“4.  Individual  trustees  or  lawyers  charged  with  the  investment  of 
large  estates,  who  are  generally  willing  to  anticipate  their  requirements  if 
anything  especially  choice  is  for  sale. 

“5.  Trust  companies  and  their  correlated  banks,  whose  purchases  may 
be  either  for  the  trust  funds  of  the  former  or  an  investment  for  the  deposits 
of  both. 

“6.  Savings  banks,  which,  taken  as  a  class,  are  the  largest  institutional 
buyers  of  the  classes  of  bonds  to  which  they  are  restricted  by  the  laws  of 
the  various  states. 

“7.  The  list  of  the  various  subsidiary  groups  among  which  the  distribu¬ 
tor  of  bonds  finds  his  best  market  might  be  extended  almost  indefinitely,  but 
those  described  will  give  a  reasonably  clear  idea  of  what  may  be  called  the 
headwaters  of  the  investment  stream  that  must  be  kept  continually  flowing 
into  the  bond  market.”1 

The  second  part  of  the  selling  program  is  the  more  difficult — that  of 
convincing  individual  investors  by  direct  and  personal  appeal  of  the  sound¬ 
ness  and  attractiveness  of  the  issue  in  question.  If  the  bond  market  is 
apathetic  or  crowded  with  issues — if,  as  the  phrase  goes,  there  are  many 
undigested  securities  floating  around — the  selling  of  the  entire  issue  may 

1  Theodore  II.  Price,  Outlook ,  CVI  (1913),  598. 


THE  SECURITY  MARKETS 


155 


prove  a  very  difficult  and  long-drawn-out  affair.  It  involves  the  use  of 
advertising  literature  sent  through  the  mails,  and  to  an  ever-increasing 
extent  it  requires  expert  salesmanship.  In  former  days  when  the  issues  of 
securities  were  few  and  when  the  announcement  of  a  new  offering  was  always 
an  event  of  importance,  advertising  literature  made  an  effective  appeal; 
but  under  present  conditions,  with  a  large  number  of  bond  houses  and  with 
thousands  of  different  issues,  the  mails  are  to  some  extent  losing  their 
effectiveness.  Much  of  this  advertising  literature  is  consigned  to  the  waste- 
paper  basket  by  the  busy  man  of  affairs  without  so  much  as  a  glance  at 
the  offer.  Personal  appeal  through  salesmen  is  increasingly  necessary  to 
bring  results.1 

“ Low-grade ”  securities  are  usually  marketed  by  the  issuers. — The 
organization  for  selling  bonds  and  stocks,  which  has  just  been  de¬ 
scribed,  is  only  available  for  the  service  of  concerns  which  have  a  fairly 
well-established  reputation,  a  strong  record  of  earnings,  or  in  the 
absence  of  these  a  very  unusual  prospect  for  the  future.  An  invest¬ 
ment  banker  can  only  do  business  profitably  by  making  repeated 
sales  to  the  same  buyers.  Hence,  his  good  will  is  his  most  valuable 
asset,  and  he  cannot  jeopardize  it  by  undertaking  to  float  speculative 
securities,  even  in  cases  where  the  prospect  of  success  is  such  as  to 
make  the  speculation  a  very  attractive  one.  The  reputation  of  an 
investment  banker  is  injured  by  a  few  flotations  which  result  in  loss 
to  investors  more  than  it  is  helped  by  numerous  cases  where  the  ven¬ 
ture  turns  out  better  than  was  anticipated.  Hence,  the  rule  of  “  safety 
first”  has  come  to  be  accepted  as  axiomatic  in  investment  banking 
quite  as  much  as  in  commercial  banking.  The  not  infrequent  cases 
where  securities  floated  through  the  stronger  investment  houses  do 
turn  out  badly  are  to  be  accounted  for  rather  by  errors  in  judgment 
than  by  any  disposition  to  take  speculative  chances. 

The  result  of  this  situation  is  that  concerns  which,  on  account  of 
their  youth  or  the  hazardous  character  of  the  business  in  which 
they  are  engaged,  cannot  meet  the  standards  of  the  investment  bank, 
find  it  much  more  difficult  to  supply  their  capital  needs.  Securities 
of  these  concerns  are  lumped  together  in  financial  literature  under  the 
caption  of  “low-grade  securities.”  The  term  is  somewhat  unfortu¬ 
nate,  as  it  carries  with  it  the  implication  that  all  securities  outside 
the  “high-grade”  class  are  inferior  in  merit.  The  class  does  include 
many  securities  which  are  issued  in  defiance  of  the  dictates  of  sound 
judgment,  and  some  which  are  downright  fraudulent,  but  it  also 

1  Adapted  by  permission  from  H.  G.  Moulton,  The  Financial  Organization  of 
Society,  pp.  234,  237-39.  (University  of  Chicago  Press,  1921.) 


RISK  AND  RISK-BEARING 


156 

includes  many  excellent  speculative  and  semispeculative  opportunities, 
and  also  many  thoroughly  sound  issues  which  are  too  small  to  receive 
attention  from  an  underwriting  house. 

New  stocks  and  bonds,  which  cannot  find  a  market  through  the 
investment  banker  are  usually  sold  by  the  issuing  corporation,  some¬ 
times  by  newspaper  advertising,  sometimes  by  circularizing  selected 
lists  of  names,  sometimes  by  contracts  with  concerns  which  are  organ¬ 
ized  to  sell  low-grade  securities  at  exorbitant  commission  rates.  The 
methods  used  in  the  marketing  of  highly  speculative  securities  are  as 
a  rule  very  different  from  those  employed  by  the  conservative  invest¬ 
ment  banker.  Flamboyant  advertising,  exaggerated  statements,  com¬ 
parisons  with  successful  enterprises  of  more  or  less  similar  character, 
and  other  methods  of  inducing  people  to  take  snap  judgment,  have 
been  used  so  frequently  both  by  promoters  of  fraudulent  schemes,  and 
by  sincere  but  mistaken  promoters,  that  the  whole  business  of  selling 
by  direct  solicitation  has  fallen  somewhat  into  disrepute,  and  perfectly 
legitimate  enterprises  are  frequently  handicapped  in  getting  capital  for 
this  reason.  The  difficulty  is  that  direct  solicitation  either  by  advertis¬ 
ing  or  by  correspondence  with  miscellaneous  individuals  whose  names 
fall  into  the  possession  of  promoters,  is  so  expensive  that  any  enterprise 
financed  in  this  way  starts  out  heavily  handicapped.  If,  as  is  not 
infrequently  the  case,  50  per  cent  of  every  investor’s  money  goes  to 
pay  the  expense  of  discovering  him  and  selling  him  a  security,  the 
enterprise  must  earn  20  per  cent  on  the  capital  actually  used,  in  order 
to  pay  10  per  cent  on  the  capital  raised.  Hence,  only  propositions 
which  have  some  chance  of  making  abnormally  high  profits  are  worth 
financing  in  this  way,  and  enterprises  which  have  a  chance  of  making 
abnormally  high  profits  nearly  always  involve  a  correspondingly  high 
degree  of  risk. 


CHAPTER  IX 

STOCK  SPECULATION  AS  BUSINESS 

ENTERPRISE 

With  this  much  information  concerning  the  market  machinery 
for  trading  in  securities,  we  are  now  ready  to  examine  the  methods  by 
which  investors  and  speculators  make  use  of  these  markets.  In  the 
present  chapter,  we  are  concerned  with  the  business  of  speculation, 
that  is,  trading  in  stocks  and  bonds,  chiefly  stocks,  for  the  sake  of  profit 
from  price  fluctuations.  Two  tasks,  therefore,  present  themselves, 
first,  a  survey  of  certain  technical  practices  which  are  associated  with 
speculative  trading,  and  second,  a  consideration  of  the  methods  used 
in  attempting  to  forecast  the  course  of  the  market  as  a  basis  for  such 
operations. 

Orders  may  be  placed  for  execution  in  either  of  three  ways:  at  the 
market ,  at  a  limit ,  or  on  stop-loss  order. — A  market  order  is  simply  an 
order  to  buy  or  sell  a  definite  number  of  shares  of  stock  (or  a  certain 
quantity  of  bonds)  at  the  best  price  obtainable.  In  the  case  of  an 
active  security,  it  may  be  assumed  that  a  market  order  will  be  executed 
at  a  price  not  far  from  the  last  quotation,  but  in  the  case  of  an  inactive 
security  a  “market”  order  of  any  considerable  size  may  have  to  be 
executed  at  a  price  far  above  the  last  price,  if  a  purchase,  or  far  below 
it,  if  a  sale.  Market  orders  have  the  advantage  of  certainty  of  execu¬ 
tion,  but  are  too  dangerous  to  find  extensive  use  outside  the  list  of 
securities  in  which  there  is  a  brisk  speculative  market. 

A  limited  order  is  an  order  to  buy  or  sell  at  a  certain  price,  or 
better.  In  the  case  of  an  order  to  buy,  for  instance,  at  70,  if  the  order 
can  be  filled  at  69  the  customer  is  entitled  to  secure  the  stock  at  that 
price,  just  as  though  the  order  had  been  placed  “at  the  market.” 
A  buying  order  with  a  limit  above  the  current  price  is  in  effect  a  market 
order,  with  a  protective  provision  to  secure  the  buyer  against  the  risk 
that  his  order  may  happen  to  find  the  market  bare  of  offerings  and 
cause  an  unexpected  advance.  A  buying  order  with  a  limit  below 
the  current  price,  on  the  other  hand,  can  only  be  executed  in  the  event 
of  a  decline.  Such  an  order  is  known  as  a  resting  order.  Sometimes 
it  is  limited  in  force  to  the  day  on  which  placed,  or  to  a  specified 
period;  sometimes  it  is  of  indefinite  duration.  Orders  of  the  latter 


157 


RISK  AND  RISK-BEARING 


153 

class  may  be  carried  on  the  books  of  the  broker  for  weeks  before  an 
opportunity  presents  itself  for  their  execution.  A  scale  order  is  a 
series  of  resting  orders  for  execution  at  specified  prices,  below  the 
market  in  the  case  of  buying  orders,  above  in  the  case  of  selling  orders. 

A  stop-loss  order  is  in  a  way  the  reverse  of  a  resting  order  to  buy 
or  sell.  An  order  to  buy  on  stop,  for  instance,  is  an  order  to  buy 
“at  the  market”  as  soon  as  a  trade  is  made  at  a  certain  price  above  the 
present  market.  Such  orders  are  used  for  several  purposes.  Their 
most  frequent  pupose  is  to  protect  speculators  from  excessive  losses  on 
single  transactions.  If,  for  instance,  A  buys  stock  at  60,  putting  up 
a  margin  of  ten  “points,”  a  stop-loss  selling  order  at  57  would  insure 
that  his  stock  would  be  sold  as  soon  as  the  market  declined  to  that 
point,  thus  reducing  the  risk  of  a  greater  loss.  It  should  be  noted 
however  that  the  stop-loss  order  does  not  furnish  a  guaranty  that  the 
loss  will  not  exceed  that  contemplated,  for  after  a  sale  is  made  at  57 
there  may  be  no  bid  for  more  stock  above,  say  55,  and,  the  broker 
must  sell  for  whatever  he  can  get.  As  a  matter  of  fact,  every  margin 
transaction  involves  a  real  stop-loss  order,  for  the  broker  will  have  to 
sell  to  protect  himself  before  the  margin  is  exhausted;  what  the  stop- 
loss  order  does  is  to  place  the  selling  point  closer  to  the  market,  thus 
increasing  the  probability  that  the  account  will  be  sold  out,  but 
decreasing  the  probable  loss  from  such  action. 

Occasionally  stop-loss  orders  are  used  when  there  are  no  open 
trades  to  be  protected,  on  the  theory  that  if  the  market  advances  to 
a  certain  point  it  will  advance  further.  For  instance,  in  an  active 
market  a  trader  reaches  the  conclusion  that  if  the  quotation  for  a 
certain  security  reaches  a  round  number,  say  100  (or  perhaps  reaches 
the  highest  point  it  has  previously  reached  during  the  year),  a  number 
of  buying  stop-loss  orders  from  short  sellers  will  be  uncovered,  and 
a  further  advance  will  result.  He  will  therefore  place  a  stop-loss  order 
at  100  with  a  limit  of  ioo|,  and  a  resting  order  to  sell  at  ioof ,  hoping 
to  shave  a  profit  out  of  the  flurry  that  will  occur  if  100  is  reached.1 

A  third  use  of  the  stop-loss  order  is  connected  with  the  operation 
known  as  pyramiding ,  which  is  the  practice  of  using  accumulated 
profits  as  margin  to  protect  further  trades.  Suppose  B  sells  short 
100  shares  of  Baldwin  Locomotive  at  125,  placing  with  his  broker 
$1,500  as  margin.  In  the  course  of  a  few  days,  Baldwin  declines  to 
120.  The  trader  now  has  twenty  points’  protection,  while  his  broker 

1  All  operations  aiming  at  small  profits  from  quick  fluctuations  are  popularly 
known  as  “scalping”  operations. 


I 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE  159 

requires  only  fifteen.  The  extra  $500  is  sufficient  to  enable  him  to 
sell  short  an  additional  25  shares  and  have  sixteen  points’  protec¬ 
tion  on  the  whole  “line”  of  125  shares.  He  does  so,  and  the  market 
continues  to  decline  till  a  price  of  1 15  is  reached.  The  profit  from  this 
further  decline  is  $625,  enough  to  margin  35  or  40  shares  additional. 
It  is  obvious  that  so  long  as  the  market  continues  to  move  in  a  down¬ 
ward  direction  the  size  of  the  order  and  the  rate  of  profit  can  be  made 
by  this  method  to  increase  in  geometrical  ratio,  and  if  no  mistakes  are 
made  concerning  the  course  of  prices  an  enormous  profit  can  be  made 
with  very  small  initial  capital.  A  stop-loss  order  is  not  essential  to 
such  an  operation,  but  is  frequently  used  both  to  control  the  pyramid¬ 
ing  process  and  to  protect  the  profits.  For  instance,  in  the  illustration 
given,  when  the  market  reached  117  the  trader  might  put  in  a  stop- 
loss  order  to  sell  40  shares  at  115,  and  another  to  buy  125  at  ii8|. 
The  selling  order  would  provide  for  the  further  development  of  the 
pyramid,  in  case  prices  continued  downward,  while  the  buying  order 
would  probably  close  out  the  trade  at  some  profit,  in  case  of  a  reversal 
of  the  trend. 

The  stop-loss  order  for  protection  is  an  utterly  illogical  device  and 
its  persistent  use  is  one  of  the  surest  roads  to  financial  ruin.  What  it 
amounts  to  is  saying  that  a  certain  security,  which  we  do  not  care  to 
buy  at  the  present  price,  we  intend  to  purchase  when  it  has  advanced 
to  a  figure  from  one  to  five  points  higher.  If  a  security  is  not  an 
attractive  purchase  at  a  given  level,  it  is  never  rendered  more  attractive 
by  an  advance,  whether  of  small  or  large  proportions,  in  its  price. 
It  is  true  that  in  certain  situations  the  stop-loss  order  is  a  useful 
protection,  but  the  careful  trader  does  not  put  himself  in  such  situa¬ 
tions.  Invariably  the  necessity  for  the  use  of  the  stop  order  goes 
back  to  one  fundamental  reason,  overtrading.  If  one’s  trades  are 
so  large  in  proportion  to  his  capital  that  an  adverse  fluctuation  of  a 
few  points  forces  him  to  close  out  or  reduce  his  line,  the  trades  are 
too  large.  Trades  made  on  account  of  exhaustion  of  margin,  or  on 
account  of  fear  of  that  contingency,  are  practically  always  contrary 
to  the  trader’s  judgment,  and  man  rarely  profits  by  putting  himself 
in  a  position  where  his  action  is  dictated  by  fear  instead  of  by  judg¬ 
ment.  Stop-loss  trades  are  fear  trades. 

The  only  case  where  an  exception  to  this  condemnation  need  be 
made  is  in  the  case  of  the  use  of  the  stop  order  to  develop  a  pyramid, 
and  even  here  its  use  is  generally  an  indication  of  overtrading.  If, 
however,  our  trader,  in  the  illustration  cited  above,  had  “inside 


I 


160  RISK  AND  RISK-BEARING 

information,”  or  for  any  reason  was  practically  certain  that  Baldwin 
Locomotive  was  about  to  decline  in  price  to  a  certain  point,  and  felt 
sure  also  that  there  would  be  no  large  fluctuations  upward  before  the 
decline  was  completed,  the  use  of  the  stop-loss  order  to  build  a  pyramid 
downward  offered  him  the  chance  of  making  the  maximum  profit  out 
of  his  limited  capital.  Such  situations  are  very  rare;  in  most  cases 
even  though  the  trader  were  right  in  his  opinion  of  the  trend  of  the 
market,  the  use  of  the  pyramid  would  insure  that  a  strong  rally  would 
“wipe  him  out”  before  the  operation  was  completed. 

Before  turning  to  the  technique  of  forecasting  market  movements, 
attention  must  be  given  also  to  certain  maxims  by  which  speculators 
sometimes  attempt  to  determine  a  profitable  line  of  individual  action. 
“Cut  your  losses  and  let  your  profits  run,”  is  a  very  common  adage 
of  the  financial  district,  for  which  there  is  very  little  basis  in  sound 
reason.  If  the  maxim  means  anything  definite,  it  must  mean  that 
the  same  price  is  a  desirable  price  at  which  to  sell  if  one  bought  a 
little  above  it,  and  an  undesirable  one  at  which  to  sell  if  one  bought 
a  great  deal  lower.  “No  one  ever  lost  any  money  by  taking  his 
profits,”  say  other  sages  of  the  market.  Even  fairly  high-grade  invest¬ 
ment  houses  and  financial  journals  sometimes  advise  clients  to  sell 
if  they  have  a  profit,  but  to  hold  on  if  they  have  a  loss.  This  is  just 
the  reverse  of  the  other  maxim,  and  is  equally  irrational.  The  fact  is 
of  course  that  the  price  at  which  a  security  was  bought  is  totally 
irrelevant  to  the  question  whether  it  should  be  sold.  If  the  chances 
seem  to  favor  an  advance,  and  no  more  profitable  use  of  funds  is  in 
sight,  presumably  securities  should  be  held;  if  they  are  expected  to 
decline,  it  is  irrational  to  hold  on  simply  because  selling  involves  taking 
a  loss,  or  because  it  does  not. 

“Averaging  down”  is  another  fallacious  method  of  speculating, 
very  similar  in  principle  to  those  just  discussed.  If,  for  instance, 
C  has  bought  fifty  shares  of  stock  at  90  and  the  price  later  declines 
to  80,  he  buys  fifty  additional  shares  at  that  price  in  order  to  reduce 
his  average  cost  to  85  and  improve  his  chances  of  getting  out  without 
a  loss.  Of  course,  the  second  trade  may  be  a  good  one,  but  in  decid¬ 
ing  whether  it  is  so  or  not,  the  price  at  which  the  first  lot  was  bought 
is  of  no  significance. 

Holding  stock  merely  because  it  was  bought  at  a  higher  price 
instead  of  selling  out  when  one  foresees  a  decline,  and  selling  to  “  take 
profits”  in  spite  of  indications  that  the  market  is  going  higher,  are 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE  161 

expressions  of  the  same  fallacy,  the  notion  that  the  past  history  of 
one’s  own  individual  account  has  a  different  significance  in  determin¬ 
ing  the  line  of  one’s  future  conduct  from  the  significance  it  has  in  the 
determination  of  anyone  else’s.  Every  decision  to  enter  on  a  new 
speculation,  or  stick  with  an  old  one,  should  rest  on  a  judgment  of 
the  future;  the  past  is  of  no  significance  except  as  an  index  of  the 
future,  and,  except  as  a  part  of  the  whole  history  of  the  market, 
one’s  own  particular  record  of  losses  or  gains  is  totally  irrelevant. 

The  exception  to  this  generalization  is  the  same  that  was  suggested 
in  connection  with  the  stop-loss  order,  that  is,  the  case  of  the  man 
who  overreaches  himself  by  trying  to  handle  trades  in  excess  of  what 
his  capital  justifies.  The  man  who  overtrades  must  cut  his  losses 
short  to  avoid  the  embarrassment  of  margin  calls,  but  by  putting 
himself  in  such  a  straitened  position  he  has  forfeited  the  privilege  of 
following  his  best  judgment. 

Let  us  turn  now  to  the  consideration  of  the  methods  used  by 
speculators  in  attempting  to  forecast  the  major  and  minor  swings  of 
prices.  Attempts  to  make  money  out  of  purchase  or  sale  of  securities 
may  be  classified  as  follows:  ( a )  speculative  trading  in  securities, 
aiming  at  quick  profits;  ( b )  speculative  trading  aiming  at  long-swing 
profits;  ( c )  investment  operations  aiming  at  high  yield  on  investment; 
(d)  investment  operations  aiming  primarily  at  safety. 

Trading  in  stocks  for  quick  profits  comprises  the  bulk  of  what  is 
commonly  known  as  stock  speculation. — The  methods  of  analysis  and 
operations  used  by  persons  engaged  in  this  kind  of  speculation  may 
be  outlined  as  follows:  ( a )  trading  on  the  technical  position;  (b) 
trading  on  the  news;  (c)  trading  on  “inside  information,”  “tips,” 
etc.;  (d)  manipulation. 

By  the  technical  position  is  meant  the  sum  total  of  conditions 
affecting  the  movement  of  prices  which  have  their  origin  in  the  opera¬ 
tions  of  the  traders  themselves.  Scientific  study  of  the  technical 
position  is  usually  equivalent  to  a  study  of  the  factors  which  determine 
the  movement  of  prices  in  the  immediate  future,  as  distinguished  from 
those  which  determine  the  trend  over  a  period  of  weeks  or  months. 
That  this  distinction  is  an  important  one  may  be  seen  from  the  fact 
that  in  a  strong  advancing  market  extending  over  several  months, 
the  prices  of  active  stocks  will  decline  on  30  or  40  per  cent  of  the  trading 
days.  The  main  elements  which  constitute  the  technical  position  are : 

1.  The  present  and  prospective  state  of  the  loan  market ,  especially 
fur  call  loans.  This  includes  both  the  interest  rate  and  the  attitude 


162 


RISK  AND  RISK-BEARING 


of  bankers  toward  speculative  collateral,  affecting  the  proportion  of 
market  value  of  stocks  which  can  be  borrowed  upon  them.  The 
speculative  markets  are  absolutely  dependent  on  the  banks  for  funds. 
Margin  buyers  pay  interest,  short  sellers  pay  none;  hence  an  advance 
in  money  rates  strengthens  the  bears  and  weakens  the  bulls.  Con¬ 
versely,  an  advance  in  the  market  increases  the  demands  on  the  banks, 
partly  because  the  same  stocks  are  now  good  collateral  for  larger 
loans  and  partly  because  advancing  prices  generally  stimulate  an 
increase  in  speculative  interest. 

For  these  reasons  the  call-loan  rate  is  very  generally  regarded  as 
a  valuable  index  of  the  strength  of  the  market,  a  rise  in  the  rate 
tending  to  force  liquidation  and  therefore  forecasting  a  decline  in 
prices. 

The  importance  of  this  factor  is  very  much  overestimated,  how¬ 
ever.  It  takes  only  a  very  small  fluctuation  in  the  price  of  a  security 
to  offset  the  interest  cost  of  several  weeks’  waiting,  and  even  a  doubling 
of  the  call-loan  rate  would  rarely  make  the  difference  between  profit 
and  loss  on  any  except  very  long-time  speculations.  Anything  which 
is  generally  believed  to  affect  prices  will  have  some  effect  on  them 
simply  because  the  effect  is  anticipated,  and  the  call-loan  rate  is 
so  emphasized  by  financial  writers  that  it  can  hardly  fail  to  have 
some  sentimental  effect,  but  its  practical  importance  is  slight.1 

2.  The  amount  of  the  floating  supply  of  speculative  securities ,  i.e., 
stocks  in  the  hands  of  brokers,  most  of  which  are  likely  to  come  on 
the  market  as  a  result  of  comparatively  slight  changes  in  price.  This 
floating  supply,  it  will  be  noted,  determines  whether  the  stock  can 
safely  be  sold  short.  A  small  floating  supply  makes  the  position  of 
the  short  seller  precarious;  many  stocks  cannot  be  borrowed  for  short 
sales  at  all.2 

3.  The  proportion  of  the  long  stock  which  is  weakly  held,  i.e.,  held 
on  small  margins  or  held  by  people  who  are  interested  in  taking  quick 
profits  and  cutting  losses  short,  as  compared  with  the  proportion  of 
stock  which  is  known  to  be  held  for  purposes  of  control  or  by  investors 
who  are  not  at  all  likely  to  sell  or  lend  the  stock. 

1  Mr.  L.  D.  Thompson  has  shown  {The  Relation  of  Call  Money  Rates  to  Slock 
Market  Speculation,  a  thesis  submitted  in  candidacy  for  the  degree  of  Master  of 
Arts  at  the  University  of  Chicago,  1922)  that  there  is  no  significant  correlation 
between  call  rates  and  the  volume  of  trading  on  the  New  York  Stock  Exchange,  and 
his  data  seem  to  indicate  also  a  lack  of  correlation  between  call  rates  and  prices 
though  the  latter  question  is  in  need  of  further  investigation. 

*  See  p.  138. 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE  163 

4.  The  size  of  the  11  short  interest  ”  (number  of  outstanding  loans  of 
stock  to  short  sellers). 

5.  Location  of  stop-loss  orders  and  resting  orders. 

6.  The  state  of  speculative  sentiment  on  the  part  of  the  public ,  the 
amount  of  free  capital  controlled  by  the  section  of  the  public  who 
display  an  interest  in  the  market. 

Judging  the  technical  position  is  not  easy. — Of  these  six  elements 
only  the  first  is  readily  ascertainable.  The  data  most  commonly 
employed  in  the  effort  to  judge  the  others  are: 

1.  Loan  rates  for  stocks.1  When  the  loan  rate  is  low,  or  a  stock 
loans  “flat,”  or  at  a  premium,  the  presumption  is  that  there  is  a  big 
short  interest  in  that  particular  security.  This  may  plausibly  indicate 
that  there  is  a  preponderance  of  expert  judgment  to  the  effect  that  the 
price  is  too  high  and  is  likely  in  the  long  run  to  fall.  Its  immediate 
significance,  however,  is  just  the  opposite,  for  it  indicates  that  there 
is  a  big  group  of  prospective  buyers  made  up  of  those  who  have  already 
sold  short.  They  will  have  to  buy  at  any  price  if  their  margins  are 
endangered  by  an  advance,  and  will  probably  buy  to  obtain  their 
profits  if  there  is  a  decline.  Hence,  the  technical  position  is  judged 
to  be  “strong.”  Too  much  confidence  should  not  be  placed  in  this 
reasoning,  however,  for  the  floating  supply  may  be  increased  at  any 
time  by  the  sale  of  loan  of  stock  which  has  been  held  outside  the 
“Street.”  (For  further  discussion  of  this  point  see  pp.  166-67.) 

2.  Public  interest ,  as  manifested  by  the  size  of  the  crowds  before 
the  brokers’  blackboards,  and  the  volume  of  orders  on  their  books. 
Increasing  interest  on  the  part  of  the  people  is  likely  to  presage 
increased  buying  power,  as  the  public  always  comes  in  after  a  dull 
market  as  a  group  of  buyers  rather  than  short  sellers.  Such  an 
increase  in  public  buying,  however,  may  be  the  signal  for  a  wave  of 
delayed  selling  by  professional  speculators,  pools,  or  insiders  in  the 
management  of  corporations  who  have  waited  for  just  such  an  oppor¬ 
tunity  to  unload  their  holdings. 

3.  Volume  of  transactions ,  as  shown  by  the  ticker  tape. 

4.  Continuity  of  quotations  and  variation  of  the  volume  of  trade 
from  day  to  day. 

5.  Charts ,  calendar  schemes ,  and  other  mechanical  forecasting  devices. 

These  last  three  methods,  which  comprise  the  favorite  field  of  the 

modern  alchemist,  may  be  discussed  together.  Of  schemes  to  forecast 

1  See  p.  130. 


164 


RISK  AND  RISK-BEARING 


the  action  of  market  by  studying  the  record  of  prices  and  volume  of 
sales  as  it  appears  on  the  ticker  tape  or  in  the  daily  papers,  there  is 
no  end.  Few  features  of  modern  business  have  received  more  minute 
study  than  has  been  devoted  to  the  attempt  to  work  out  a  mechanical 
method  of  judging  from  the  present  and  past  condition  of  the  market 
what  its  future  is  going  to  be.  “Tape  readers”  study  the  fluctuations 
of  prices  from  hour  to  hour,  record  the  volume,  and  attempt  to  fore¬ 
cast  the  immediate  future,  trading  for  profits  of  an  eighth  to  a  half 
point.  Chart  artists  trace  the  movement  of  prices  of  selected  groups 
of  stocks  and  attempt  to  draw  conclusions  from  the  shape  of  the  curve. 
“Calendar  traders”  scrutinize  the  stock-exchange  quotations  for 
evidence  of  seasonal  tendencies,  and  express  their  conclusions  by  such 
phrases  as  the  “January  rise,”  the  “spring  rise,”  etc.  Most  of  this 
sort  of  study  is  obviously  wasted  effort.  The  generalizations  are 
usually  based  upon  the  experience  of  a  comparatively  short  period, 
five  or  seven  years  in  the  case  of  the  calendar  trader  and  six  or  eight 
coincidences  in  the  case  of  the  chart  plan.  Even  if  such  coincidences 
are  not  accidents,  but  due  to  some  continuing  cause,  it  does  not 
follow  that  this  unknown  force  will  continue  to  produce  the  same 
effect.  If  no  other  force  comes  in  to  change  the  future,  the  very 
fact  that  a  regularity  is  great  enough  to  be  observed  by  numerous 
traders  constitutes  a  force  disturbing  the  sequence  of  price  movements 
in  the  future.  If,  for  instance,  there  is  a  tendency  for  several  years 
in  succession  for  stocks  to  rise  in  January,1  perhaps  on  account  of 
dividend  disbursements  reinvested  around  January  1,  the  more 
regularly  the  phenomenon  appears,  the  more  certainly  will  there  be 
a  bunching  of  purchases  just  ahead  of  the  date  when  the  rise  is  due  in 
order  to  sell  on  the  rise;  and  these  operations  may  cause  the  rise  to 
appear  earlier  and  to  be  followed  by  an  earlier  decline.  It  would  be 
rash  indeed  for  anyone  to  say  that  none  of  these  mechanical  methods 
has  any  value,  for  no  one  has  tested  them  all,  and  the  more  valuable 
any  method  proves  itself  to  be  the  less  likely  are  its  discoverers  to  give 
it  publicity.  So  far  as  can  be  judged,  however,  from  a  survey  of  the 
rather  extensive  literature  of  stock  speculation,  there  are  few  less 
promising  ways  of  making  an  income  than  attempts  to  “beat  the 
tape”  by  a  study  of  the  tape  itself. 

It  does  not  follow,  however,  that  a  study  of  the  data  revealed  by 
the  tape  is  of  no  significance  whatever  in  forecasting  the  course  of 

1  The  careful  studies  published  by  the  Harvard  Committee  on  Economic 
Research  in  the  Review  of  Economic  Statistics  indicate  that  there  is  no  seasonal 
fluctuation  in  the  prices  either  of  industrial  stocks  or  of  high-grade  bonds. 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


165 

prices.  There  are  apparently  certain  relationships  between  the 
volume  of  trading  and  the  course  of  the  typical  stock-exchange 
cycle  which  are  useful  as  a  supplement  to  other  methods  of  analysis. 
The  following  quotations  summarize  all  that,  in  the  author’s  opinion, 
can  safely  be  said  with  regard  to  this  phenemenon: 

How  much  attention,  if  any,  should  the  “investor  for  profit”  pay  to 
the  stock  market  from  day  to  day  or  from  week  to  week  ?  Has  he  anything 
to  gain  from  watching  current  fluctuations  and  volumes,  or  studying  the 
general  behavior  of  the  market  ? 

We  may  answer  at  once  that  he  should  pay  relatively  little  attention 
to  these  things.  Earnings  and  values,  growth  of  population  and  of  business, 
dividends  and  money  rates,  political  conditions  and  the  accumulation  of 
capital  in  the  banks,  are  of  far  more  importance  and  significance  to  the 
investor  than  any  indications  he  can  draw  from  the  temporary  and  often 
erratic  fluctuations  of  prices. 

Yet  this  question  of  the  action  of  the  market  should  not  be  entirely 
ignored.  It  is  a  well-known  fact  that  some  professional  speculators  are 
able,  by  carefully  watching  the  technical  indications  derived  from  a  study 
of  volumes  and  prices,  to  make  more  money  during  the  year  than  they  lose. 

Reduced  to  its  lowest  terms,  the  action  of  the  market  includes  only 
three  basic  factors:  (1)  price;  (2)  time;  (3)  volume;  that  is,  the  number 
of  shares  bought  and  sold  at  a  certain  price  or  during  a  certain  time. 

Each  of  these  three  factors  may  be  recorded  or  used  in  different  ways, 
and  the  three,  or  any  two  of  them,  may  be  combined  according  to  different 
plans. 

First,  no  important  conclusions  can  be  obtained  from  any  one  of  the 
three  factors,  taken  alone.  It  is  the  varyihg  relations  between  two  or  three 
of  them  that  serve  to  give  the  market  a  sort  of  character  of  its  own. 

Second,  the  element  of  time  must  always  be  included.  Thousands  of 
students  have  wasted  a  great  deal  of  more  or  less  valuable  brain-power  in 
trying  to  draw  conclusions  from  a  combination  of  prices  and  volumes, 
without  reckoning  in  the  lapse  of  time.  In  my  opinion,  it  can’t  be  done. 

Third,  a  study  of  time  and  volume  without  prices  would  be  meaning¬ 
less,  as  the  investor  cannot  buy  or  sell  except  at  some  price. 

Common  sense  tells  us  that  the  lowest  prices  are  likely  to  be  made  when 
most  people  are  trying  to  sell,  and  the  highest  prices  when  the  greatest 
number  are  anxious  to  buy.  We  shall  expect,  then,  that  the  volume  of 
sales  will  be  relatively  large  at  the  top  and  the  bottom,  and  this  conclusion 
is  borne  out  by  history. 

A  heavy  trade  in  stocks  is  pretty  sure  to  be  accompanied  by  relatively 
wide  fluctuations  in  prices — the  whole  market  gets  bigger,  in  every  way. 
So  we  find  that  at  these  turning  points  the  range  of  prices  for  the  day,  as 
shown  by  the  length  of  the  lines  on  the  graphic  connecting  the  average 
high  with  the  average  low,  will  be  relatively  wide. 


i66 


RISK  AND  RISK-BEARING 


After  a  period  of  heavy  selling  pressure,  buyers  are  not  likely  to  rush 
in  the  moment  the  selling  ceases.  They  fear  a  renewal  of  the  liquidation, 
and  will  only  begin  to  buy  gradually,  as  the  market  becomes  quieter  and 
more  settled.  Consequently  a  period  of  activity — that  is,  big  volumes  and 
wide  daily  ranges — at  low  prices,  is  usually  followed  by  a  time  of  dullness 
without  any  very  great  change  in  the  general  level. 

The  same  principle,  of  course,  applies  after  great  activity  at  high  prices; 
but  the  period  of  activity  may  be  longer  and  the  period  of  dullness  shorter 
than  at  the  bottom,  because  speculation  is  naturally  broader  at  high  prices 
and  the  public  participation  in  the  market  more  general. 

Probably  the  best  indication  of  the  trend  of  the  market,  that  is  easily 
available  to  everybody,  is  found  in  the  comparison  of  the  total  volume  of 
trade  on  days  when  the  market  moves  sharply  upward,  and  the  volume  on 
declines.  In  a  bull  market,  buyers  come  in  on  the  advances.  In  a  bear 
market,  they  refuse  to  do  so.  In  a  bear  market,  holders  are  urgent  to  sell 
on  declining  prices.  In  a  bull  market,  they  hold  on  stubbornly. 

The  result  is  that,  in  a  bull  market,  the  volume  of  trade  is  likely  to 
increase  on  the  advances,  while  in  a  bear  market  it  will  probably  become 
heavier  on  declines.  But  this  principle  can  only  be  interpreted  and  applied 
to  the  market  by  long  study  and  careful  observation.  The  novice  finds 
many  stumbling  blocks. 

One  of  them  is  that  he  is  almost  sure  to  lay  too  great  weight  on  small 
movements,  caused  only  by  professional  operations.  Professional  traders 
make  prices  temporarily,  but  they  have  very  little  influence  on  the  general 
trend  of  prices  over  a  considerable  period.  They  are  merely  trying  to  follow 
this  trend,  not  to  make  it.  The  attitude  of  investors  creates  the  trend,  and 
no  useful  indications  as  to  its  direction  can  be  gained  from  fluctuations 
caused  only  by  professional  speculators.1 

The  difficulties  involved  in  attempts  to  predict  the  market’s 
course  on  the  basis  of  its  own  action  are  summarized  by  an  experienced 
trader  as  follows: 

It  might  be  supposed  that  the  borrowing  demand  for  stock  would  serve 
as  an  indication  of  the  extent  of  the  short  interest,  but  as  a  matter  of  fact 
it  is  of  little  value  in  that  direction.  In  the  first  place,  the  borrowing  may 
be  by  a  short  interest  of  an  “investment”  character,  which  cannot  be 
driven  to  cover  and  therefore  does  not  create  an  “oversold”  market  in  the 
ordinary  sense  of  that  word. 

Second,  the  stocks  borrowed  may  be  to  temporarily  take  the  place  of 
long  stocks  sold  by  previous  holders  whose  certificates  have  not  yet  arrived 
in  New  York  from  abroad  or  from  other  cities,  or  even  for  holders  who  have 
delayed  getting  their  certificates  out  of  their  vaults  and  delivering  them. 

1  Taken  by  permission  from  G.  C.  Selden,  hivesting  for  Profit,  137-48.  (Maga¬ 
zine  of  Wall  Street,  1913.) 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


167 


A  large  interest  may  sometimes  prefer  to  have  its  liquidating  sales  appear 
to  be  short  sales  until  it  has  disposed  of  its  entire  line,  thus  avoiding  any 
premature  filling  up  of  the  Street  with  certificates,  which  might  help  to 
depress  prices. 

How  then  are  we  to  find  out  the  amount  of  the  short  interest  ?  Some 
line  on  the  situation  can  be  obtained  by  talking  with  active  brokers.  True, 
the  broker  can  only  express  his  opinion,  formed  from  such  opportunities 
for  observation  as  he  may  have.  For  that  reason,  his  words  cannot  be 
accepted  as  gospel.  In  fact,  it  will  often  happen  that  one  broker  thinks 
the  market  is  oversold  while  another  sees  no  special  evidence  of  any  extended 
short  interest.  Nevertheless  the  broker  has  a  much  better  opportunity 
of  getting  this  information  than  the  outside  investor,  and  his  opinion  should 
be  duly  considered. 

Coming  to  the  position  of  big  operators,  this  is  as  a  rule  very  difficult 
to  ascertain  and  the  average  outside  speculator  can  rarely  allow  himself 
to  be  much  influenced  by  it.  Most  of  the  gossip  floating  around  the  Street 
as  to  what  Morgan,  Kuhn-Loeb,  or  the  City  Bank  is  doing  in  the  market 
is  worse  than  valueless . 

The  task  of  finding  out  what  big  interests  are  doing  in  the  market  is 
not  absolutely  impossible,  but  it  is  almost  as  difficult  as  learning  to  judge 
the  market  correctly  yourself.  For  that  reason  your  main  reliance  must 
always  be  on  yourself,  and  such  reports  are  always  to  be  regarded 
suspiciously. 

Sincere  reports  from  the  floor  as  to  the  position  and  sentiments  of  the 
majority  of  the  traders  are  not  usually  very  difficult  to  get  from  your 
broker,  but  I  am  obliged  to  admit  that  I  have  never  got  much  benefit  from 
them.  Floor  traders  rarely  agree  in  their  views  and  as  their  opinions  are 
usually  formed  from  the  surface  indications  which  flicker  back  and  forth 
before  their  eyes,  their  sentiments  are  likely  to  change  with  a  suddenness 
and  completeness  which  are  confusing  to  the  outsider.  They  willingly 
report  what  they  see,  but  I  doubt  very  much  whether  the  outsider  can  make 
much  profitable  use  of  their  reports . 

The  presence  of  stop  orders  above  or  below  the  current  plane  of 
prices  will,  if  they  are  in  any  considerable  volume,  have  a  decided  effect  on 
the  trader’s  position.  The  first  question  in  this  connection  is:  How  are 
we  to  discover  whether  such  stop  orders  are  present  or  not  ? 

The  reports  on  this  subject  which  are  from  time  to  time  heard  floating 
around  the  Street,  or  are  ’phoned  by  customers’  men  to  their  more  active 
following,  are  hardly  ever  to  be  taken  at  their  face  value.  This  is  chiefly 
because  actual  information  about  stop  orders  is,  as  a  rule,  unobtainable. 
Reports  on  the  subject  are  pretty  sure  to  be  guess  work . 

Of  course  the  most  important  stop  orders  are  not  put  on  the  floor.  In 
fact  they  usually  do  not  exist  anywhere  except  in  the  mind  of  the  operator. 


i68 


RISK  AND  RISK-BEARING 


He  has,  let  us  say,  a  big  line  of  Steel  common.  He  makes  up  his  mind  that 
if  Steel  declines  to  62  he  will  close  out  his  line,  as  that  much  decline  would 
indicate  to  him  that  his  judgment  of  the  situation  has  been  wrong. 

Such  a  determination  on  the  part  of  the  operator  is  exactly  equivalent 
to  a  stop  order  on  his  holdings  of  Steel  at  62;  but  there  is  no  record  of  that 
determination  anywhere,  and  no  possible  way  of  getting  information  about 
it  in  advance.  The  operator  does  not  tell  his  broker  to  put  a  stop  at  62, 
because  he  very  well  knows  that  such  a  course  would  invite  attack.  If 
through  any  “leak” — and  it  is  very  difficult  for  any  brokerage  house,  no 
matter  how  honorable,  to  stop  all  possible  leaks — the  fact  became  known 
to  the  floor  traders  that  a  big  line  of  Steel  would  be  stopped  out  at  62,  they 
would  all  be  expecting  the  price  to  decline  to  62,  and  would  therefore 
hesitate  to  buy  even  if  they  did  not  take  the  short  side.  The  small  trader, 
of  course,  need  not  hesitate  to  put  in  his  stop  in  advance.  He  is  merely  a 
fly  on  the  wheel,  and  his  position  will  have  no  perceptible  effect  on  the 
market. 

You  always  have  to  remember  that  when  you  feel  a  certain  way  about 
the  market,  a  lot  of  other  people  are  feeling  just  the  same  way.  What  you 
have  to  do  is  to  be  a  little  bit  cleverer  than  the  others — for  example,  to 
buy  when  the  stop  orders  are  executed  around  150.  Then  you  can  safely 
enough  put  in  your  own  stop  at  perhaps  149  after  the  market  has  turned 
upward.  But  it  takes  you  a  number  of  years  to  get  to  be  cleverer  than 
others — cleverer  than  the  market,  in  other  words — and  in  the  meantime 
you  are  very  likely  to  put  your  stop  in  the  wrong  place . 

In  a  general  way  we  can  get  some  idea  of  the  situation  by  noting  whether 
transactions  increase  or  decrease  on  the  declines.  Short  sales  may,  it  is 
true,  produce  a  moderate  and  temporary  increase  in  business  on  declines, 
but  any  important  or  persistent  increase  may  always  safely  be  set  down  as 
evidencing  sales  by  actual  owners  of  the  certificates.  In  order  to  do  more 
business  at  lower  prices,  traders  and  speculators  must  very  soon  get  hold  of 
more  stock  which  may  be  bought  and  sold.  If  instead  of  finding  more 
stocks  in  the  floating  supply  after  a  decline  they  find  fewer  stocks,  transac¬ 
tions  will  quickly  shrink  and  a  trapped  short  interest  will  soon  have  to  buy 
back  its  sales  at  higher  prices  than  where  they  were  put  out. 

Suppose  prices  decline  rapidly  on  a  big  volume  of  trade  for  perhaps  two 
weeks,  with  relatively  wide  fluctuations  in  the  leading  speculative  stocks 
from  day  to  day.  Then  from  near  bottom  prices  we  have  a  sharp  rally 
for  several  days,  caused  by  covering  of  shorts.  After  that  the  market 
grows  dull  and  drifts  slowly  downward  for  two  or  three  weeks,  with  transac¬ 
tions  much  smaller  than  on  the  previous  decline  and  with  a  narrower  range 
of  daily  fluctuations.  This  is  a  plain  case,  and  it  generally  occurs  in  sub¬ 
stantially  the  way  above  outlined  several  times  in  every  year.  It  shows 
three  steps,  which  always  occur  when  the  market  strikes  bottom  and  turns 
upward: 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


169 


(1)  Liquidation  by  investors  and  traders  who  have  become  discouraged, 
either  by  the  unfavorable  outworking  of  the  whole  situation  or  by  specific 
bear  news. 

(2)  Partial  cessation  of  such  liquidation,  quickly  followed  by  covering 
of  shorts  which  had  been  put  out  during  the  decline,  causing  a  rally. 

(3)  A  period  of  rest,  accompanied  by  a  small  amount  of  left-over 
liquidation  and  by  scalping  short  sales,  the  latter  practically  all  by  pro¬ 
fessionals  and  semi-professionals. 

After  this  process  the  market  is  ready  to  respond  to  favorable  news  when 
it  comes,  and  will  decline  but  little  on  further  bear  news,  unless  it  is  of  a 
very  sensational  character. 

What  has  really  occurred  is  that  the  floating  supply  of  stocks,  which  had 
been  increased  by  liquidation,  has  little  by  little  been  absorbed.  Some 
investors  were  buying  on  a  scale  during  the  first  decline.  Others  bought 
when  they  thought  the  market  has  turned.  Still  others  were  busy  picking 
up  stocks  during  the  third  period  above  described,  so  that  every  evidence 
of  temporary  weakness  resulted  in  scattering  buying  orders.1 

T rading  on  the  news  involves  great  risks. — The  second  great  method 
of  speculating  for  the  short  swing  is  trading  on  the  news.  There  is  no 
place  in  the  world  where  so  much  attention  is  paid  to  the  gathering, 
dispensing,  and  study  of  the  current  news  as  in  the  speculative  invest¬ 
ment  markets.  Outside  of  the  news  of  sports,  the  want  ads,  the 
divorces,  and  the  crimes  there  is  little  in  the  daily  newspaper  which 
does  not  have  a  bearing  on  the  incomes  of  businesses,  big  and  little, 
and  hence  upon  the  value  of  securities.  But  the  newspaper  is  too 
slow  and  too  little  specialized  to  meet  the  demands  of  the  speculative 
public,  so  an  elaborate  system  of  specialized  information  service  has 
been  developed.  Of  this  apparatus,  the  most  important  parts  are 
the  news  ticker,  the  Bulletin  Service,  the  market  letters,  and  the 
reviews  furnished  by  the  professional  financial  service  bureaus.  Of 
these,  the  quickest  is  the  news  ticker  or  broad-tape  service,  a  collection 
of  bits  of  general  political  and  economic  news,  corporation  reports  and 
brokers’  gossip,  which  is  sent  out  over  leased  telegraph  wires  and 
printed  simultaneously  in  every  important  brokerage  office  in  the 
country. 

Slightly  slower  than  the  ticker,  but  fuller,  is  the  hourly  or  half- 
hourly  Bulletin  Service  published  in  eastern  cities.  Some  brokerage 
houses  issue  daily  market  letters  which  purport  to  explain  the  action 
of  the  day’s  market  and  make  cautious  predictions  of  the  nearby 

•  1  Adapted  by  permission  from  Browne,  Practical  Points  on  Stock  Trading , 
35-49,  55-64.  (Magazine  of  Wall  Street,  1918.) 


170 


RISK  AND  RISK-BEARING 


future;  others  issue  more  pretentious  weekly  reviews  which  discuss 
the  general  economic  situation  and  also  summarize  the  known  facts 
concerning  the  situation  of  individual  companies. 

Trading  on  the  general  news  is  simpler  than  trading  on  the  tech¬ 
nical  position,  and  looks,  at  first  glance,  to  be  a  more  sensible  pro¬ 
cedure.  “Values  are  subject  to  constant  change,”  runs  the  reasoning 
back  of  this  method  of  procedure.  “The  changes  all  have  causes, 
and  these  causes  must  in  large  part  appear  in  the  news.  Trading  on 
the  news  after  everyone  has  it  obviously  promises  no  profits;  the 
important  thing  is  time.  Our  business  is  to  anticipate  other  men’s 
decisions  to  buy  or  sell,  and  to  do  this  we  must  get  the  news  before 
they  do.”  This  reasoning  is  sound  enough,  yet  there  is  no  reason  to 
believe  that  people  who  make  a  practice  of  buying  Bulletin  Services 
or  frequenting  brokers’  offices  to  keep  in  touch  with  the  latest  informa¬ 
tion  actually  make  money  by  so  doing.  A  fourfold  difficulty  obstructs 
all  attempts  to  make  money  in  this  way.  In  the  first  place,  the  impor¬ 
tant  news,  the  items  that  will  cause  a  real  change  in  the  level  of  stock 
prices,  such  as  supreme-court  decisions  or  declarations  of  war,  arc 
known  to  a  great  many  people  before  they  appear  even  on  the  broad 
tape,  and  are  pretty  accurately  anticipated  by  a  great  many  more, 
so  that  even  the  most  studious  frequenter  of  the  broker’s  room  is  apt 
to  be  too  late.  In  the  second  place,  speed  is  gained  in  these  services 
at  the  sacrifice  of  accuracy.  Like  the  daily  press,  the  news  services 
abound  in  unverified  rumors,  some  of  which  are  probably  put  out  for 
the  deliberate  purpose  of  influencing  the  market,  but  many  merely  to 
fill  space.  In  the  third  place,  on  nine  out  of  ten  days  there  is  no  news 
of  sufficient  importance  to  justify  anybody  in  changing  his  market 
position,  and  in  the  absence  of  really  significant  news  the  tape  and 
the  bulletins  are  filled  up  wflth  actual  information  which  is  indeed  more 
or  less  relevant  to  the  general  financial  situation  but  is  so  slight  in  its 
significance  and  so  great  in  its  mass  that  it  creates  only  confusion. 
Finally,  the  Wall  Street  news  services  are  themselves  read  by  so  many 
people  that  any  given  individual  finds  it  difficult  to  profit  greatly  by 
being  one  of  those  who  get  the  news  through  them.  Prices  adjust 
themselves  to  the  known  elements  of  a  situation  with  astonishing 
rapidity,  and  there  is  no  commoner  error  than  trying  to  make  a  profit 
by  trading  on  news  which  is  already  fully  discounted  before  one’s 
order  comes  to  the  floor. 

The  following  comment,  by  the  editor  of  a  prominent  financial 
journal,  summarizes  the  situation  well: 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


171 

So  far  as  the  news  is  concerned,  there  are  two  kinds:  known  and 
unknown.  Known  news  is  what  we  find  on  news  slips,  news  tickers,  news¬ 
papers  and  the  usual  run  of  market  letters.  Known  news  is  what  has  hap¬ 
pened  and  has  been  told.  It  becomes  public  property  the  moment  it  is 
printed  in  Wall  Street.  News  known  to  everybody  is,  except  in  rare  cases, 
of  little  use  to  anybody.  Yet  the  great  public  thirsts  for  news,  talks  news 
and  trades  on  news.  Market  letters  of  brokerage  houses  are  practically 
all  based  on  an  analysis  of  known  stock  market  factors;  also  newspaper 
financial  articles  and  “reviews  and  outlooks.” 

One  need  spend  but  a  few  months  in  Wall  Street  to  find  that  the  move¬ 
ments  of  the  market1  cannot  consistently  be  reconciled  to  the  news,  statistics, 
earnings,  outlook  or  such  other  considerations  as  largely  influence  the  general 
public.  Almost  every  day  we  see  the  market  advance  on  bad  news  or  break 
in  spite  of  favorable  developments.  It  is  impossible  to  analyze  the  effect 
of  a  certain  situation  upon  the  minds  of  a  million  people  who  are  interested 
in  the  market,  either  as  investors  or  as  speculators.  Wall  Street  is  a  great 
“hopper,”  into  which  all  day  long  there  pours  an  unceasing  stream  of  news, 
statistics,  decisions,  railroad  and  industrial  reports,  Government  estimates, 
court  rulings,  corporation  announcements,  and  last,  but  not  least,  rumors 
and  tips. 

All  this  news  and  all  these  facts  and  rumors  and  tips  which  are  poured 
into  the  “financial  hopper”  have  a  certain  influence  on  the  minds  of  traders 
and  investors,  causing  them  (directly  or  indirectly)  to  buy  or  sell. 

We  frequently  notice  squibs  in  the  papers  to  the  effect  that  “  the  advance 
in  Reading  was  due  to  the  company’s  favorable  monthly  report,”  or  some 
expression  of  that  kind.  One  can  readily  see  how  impossible  it  would  be 
for  the  reporter  who  writes  this  paragraph  to  ascertain  just  why  those  who 
bought  and  sold  during  the  day,  did  so.  In  order  to  make  such  a  statement 
with  any  degree  of  accuracy  it  would  be  necessary  to  communicate  with  each 
buyer  and  seller  for  the  day,  extract  from  him  the  reason  why  he  made  the 
trade  and  strike  a  balance.  These  buyers  and  sellers  may  be  scattered  all 
over  the  earth,  dealing  in  one,  ten,  fifty  or  one  thousand  share  lots.  It  is, 
therefore,  absurd  to  place  any  reliance  on  statements  that  this  or  that  was 
the  cause  of  the  advance  or  the  decline.  This  not  only  emphasizes  the 
necessity  of  taking  newspaper  reports  with  a  grain  of  salt,  but  proves  that 
no  one  actually  knows  what  produces  these  small  advances  and  declines, 
although  there  are  a  great  many  people  who  guess  about  it.3 

Trading  on  “ inside  information”  is  very  common. — The  third 
method  of  short-time  speculation  is  trading  on  “inside  information,” 

1  The  reference  is  to  short  swings,  not  to  the  major  changes  which  require  months 
or  years  for  their  completion  (ed.). 

2  Adapted  by  permission  from  Richard  D.  Wyckoff,  “Why  the  Action  of  the 
Market  Is  a  Better  Guide  than  the  News  or  the  Fundamentals,”  Magazine  oj  Wall 
Street ,  March  19,  1921,  pp.  709-10. 


1 72 


RISK  AND  RISK-BEARING 


that  is,  information  not  yet  available  to  the  general  public.  The  only 
generalization  which  can  be  made,  with  reference  to  the  value  of  this 
sort  of  material,  is  that  it  all  depends  on  the  source  from  which  the 
information  comes.  The  vast  majority  of  the  so-called  tips  which 
float  around  the  customers’  rooms  of  the  brokerage  offices  are  worth¬ 
less.  Especially  is  this  true  of  the  information  in  regard  to  the  doings 
of  prominent  operators,  a  popular  basis  of  trading  among  small -fry 
speculators.  On  the  other  hand,  advance  information  of  the  condi¬ 
tion  of  corporation  reports,  and  of  changes  in  the  dividend  policy  of 
important  corporations,  is  nearly  always  available  to  a  sufficient 
number  of  people,  so  that  its  market  influence  is  shown  from  one  to 
three  or  four  days  ahead  of  the  public  announcement.  Boards  of 
directors  have  often  been  severely  criticized  on  account  of  stock-market 
movements,  which  indicate  that  they  have  themselves  operated  on 
the  knowledge  of  their  own  actions  to  the  detriment  of  other  stock¬ 
holders,1  or  have  improperly  given  advantages  to  a  favored  few.  The 
directors  are  not  always  at  fault,  however.  There  are  many  other 
chances  for  leaks.  Employees  of  public  accountants’  offices  often 
know  the  essential  features  of  a  corporation’s  annual  statement  before 
the  officers  of  the  corporation  know  them.  Stenographers  and  tele¬ 
phone  operators  must  be  taken  into  the  confidence  of  the  management. 
Tips  from  such  sources  as  these  may  exercise  an  influence  in  the  market 
for  which  the  directors  are  blamed.  However,  there  is  no  reason  to 
doubt  that  many  corporation  directors  do  consider  it  legitimate  for 
them  to  trade  in  the  securities  of  their  own  corporations  on  the  strength 
of  their  advance  information.  To  quote  Mr.  Wyckoff  again: 

Unknown  news  consists  of  important  facts  in  possession  of  a  few  insiders. 
It  is  the  possession  of  these  facts  which  distinguishes  the  insider  from  the 
public.  The  insider  works  with  an  incalculable  advantage.  Reports  of 
earnings,  probability  of  reduced  or  increased  dividends,  etc.,  must  be  known 
to  some  one  person  or  a  few,  before  public  announcement  can  be  made. 
This  may  take  place  a  few  minutes,  hours,  days  or  weeks  later,  according 
to  market  conditions  and  the  position  of  the  insiders.  Meantime  those 
who  trade  on  the  news  which  is  known  are  simply  playing  into  the  insider’s 
hands. 

The  insider  does  what  probably  you  would  do  if  you  were  in  his  place. 
During  the  interval  between  his  receiving  and  announcing  the  news,  he 
telephones  his  broker  and  gives  his  order.  This  takes  but  a  moment.  If 
he  is  a  big  enough  factor,  some  manipulation  may  accompany  his  buying 


1  The  Rock  Island  receivership  was  a  comparatively  recent  case  in  point. 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


173 


or  selling;  but  whether  his  operations  are  large  or  small,  there  is  usually 
a  coterie  of  associates  who  act  with  him  or  upon  his  information. 

Each  of  the  persons  composing  this  group  has  his  own  broker,  and  each 
broker  his  own  clientele.  It  is  customary  for  a  broker  who  sees  inside 
orders  coming  through,  to  advise  certain  of  his  clients  in  accordance  there¬ 
with,  without  necessarily  disclosing  the  actual  source.  For  example,  the 
broker  will  say,  “Now  Jones,  I  want  you  to  buy  some  of  this  stock.  I  can’t 
tell. you  what  I  know,  but  there  is  excellent  buying  going  on,  and  if  you  will 
take  on  a  little,  I  believe  you  will  make  some  money.”  Thus  unknown 
news  becomes  the  power  behind  a  movement  which  may  attain  large  pro¬ 
portions  before  public  announcement  is  made — when  the  unknown  news 
becomes  known  news. 

However  desirable  this  unknown  news  or  “inside  information”  may  be, 
getting  it  from  its- original  sources  is  beyond  the  reach  of  the  average  trader. 
And  even  if  he  had  “underground”  connections  with  every  important  source 
of  information  in  the  Street,  there  would  be  no  certainty  that  he  could  always 
profit  thereby.  Insiders  are  often  completely  surprised  and  suffer  heavy 
losses  on  account  of  an  adverse  trend  of  the  market,  some  other  and  more 
effective  news,  an  accident  or  the  operations  of  opposing  speculative  pools 
and  large  individual  traders.  One  clique  may  possess  a  bit  of  knowledge 
which,  in  their  opinion,  will  produce  a  certain  market  effect;  another 
group  may  command  greater  resources,  swing  larger  lots,  diffuse  more 
effective  “information.”  Group  One  may,  therefore,  find  its  efforts  futile. 

Then  we  must  consider  the  “sentiment”  of  the  Street,  which  is  fre¬ 
quently  more  powerful  than  any  group  of  operators.  In  former  years, 
manipulatory  able  to  swing  fifty  or  a  hundred  thousand  shares  could  practi¬ 
cally  dominate  the  market;  but  in  these  days  of  hundred  million  dollar 
issues  and  billion  dollar  capitalizations,  everybody  is  stronger  than  anybody. 
At  such  times  “inside  information”  is  likely  to  ruin  one  who  follows  it  in 
the  face  of  overwhelming  buying  or  selling  by  the  public.  In  other  words, 
insiders  are  not  invariably  correct.  It  is  an  old  saying  that  “inside  informa¬ 
tion  ”  will  break  anyone.1 

“ Manipulation ”  is  difficult  to  detect. — The  fourth  method  of 
speculation  for  the  short  turn  is  manipulation,  by  which  we  mean  all 
operations  aiming  at  a  profit  from  a  change  in  the  market  which  the 
operator  himself  causes,  either  by  the  sheer  weight  of  his  own  opera¬ 
tions  or  by  coloring  the  news,  or  often  by  a  combination  of  both 
methods.  Manipulation  is  only  possible  through  large-scale  opera¬ 
tions,  and  the  number  of  people  who  can  engage  in  it  is  comparatively 
small,  though,  by  pooling  their  capital  and  intrusting  the  management 
of  their  campaign  to  a  single  manager,  a  group  of  individuals  can 

lLoc.  cit. 


174 


RISK  AND  RISK-BEARING 


influence  the  market  as  much  as  a  single  operator  owning  much  larger 
capital.  Such  pool  operations  are  probably  very  common,  but  au¬ 
thentic  information  concerning  their  activities  seldom  reaches  the  pub¬ 
lic.  The  following  reading  describes  typical  manipulation  methods: 

There  may  be  said  to  be  three  principal  forms  of  manipulation,  apart 
from  those  that  were  formerly  conducted  through  what  are  known  as 
“wash  sales”  and  fictitious  transactions,  which  have  largely  been  abandoned, 
and  others  which  it  will  not  be  necessary  to  discuss. 

1.  The  most  common  and  most  vicious  form  is  effected  by  what  are  in 
substance  bogus  purchases  and  sales  to  create  a  false  appearance  of  activity 
for  the  purpose  of  unloading  the  stock  on  the  public  at  high  prices.  The 
same  person  or  group  gives  buying  orders  to  one  set  of  brokers  and  selling 
orders  to  another  but  the  selling  orders  exceed  in  volume  the  buying  orders 
until  the  stock  is  marketed.  The  apparent  purchases  and  sales  may  and 
often  do  exceed  the  actual  purchases  by  the  public  ten  or  twenty  over.  In 
order  to  actually  unload  one  hundred  shares  on  the  public  the  manipulator 
may  have  to  apparently  deal  in  thousands  of  shares.  So  long  as  commissions 
are  paid  on  these  sham  transactions  on  both  sides  of  the  bargain  the  Exchange 
has  regarded  them  as  entirely  legitimate,  even  though  the  real  nature  of 
the  dealing  is  apparent  from  their  volume  and  from  general  report  and  can 
readily  be  verified  from  the  books  of  the  brokers,  to  which  the  Exchange 
has  free  access  at  all  times. 

2.  A  series  of  transactions  conducted  for  the  purpose  of  acquiring  or 
selling  a  large  block  of  the  stock  of  a  given  corporation  not  for  investment 
but  with  the  intent  of  realizing  an  immediate  profit,  brought  about  by 
purchases  and  sales  that  are  calculated  to  affect  the  price  in  the  way  best 
adapted  to  accomplish  the  end  in  view.  If  the  purpose  be  to  accumulate 
stock  so  as  to  sell  at  a  substantially  higher  level,  the  plan  involves  selling 
part  of  the  accumulations  as  the  stock  rises  so  as  to  depress  the  price  and 
then  make  larger  purchases.  If  the  intention  is  to  sell  the  opposite  course 
is  adopted.  The  ultimate  object  is  to  buy  stock  that  you  do  not  want  or  to 
sell  stock  that  you  do  want  with  the  view  of  affecting  the  price. 

3.  Where  a  new  security  is  to  be  introduced,  instead  of  advertising  its 
merits  by  the  publication  of  a  prospectus  or  by  open  solicitation,  the  security 
is  here  again  given  a  false  appearance  of  activity  to  attract  dealings.  After 
the  public  has  been  led  to  buy  on  the  assumption  that  it  is  acquiring  a 
security  with  an  active  market  that  is  readily  saleable,  those  who  were 
interested  in  creating  this  impression  and  who  have  probably  disposed  of 
the  stock  they  had  to  sell  find  it  unnecessary  to  continue  the  heavy  expense 
of  paying  out  commissions  on  what  are  in  effect  fictitious  transactions,  and 
the  buyers’  apparently  active  market  gradually  and  sometimes  suddenly 
fades  away.1 

‘Taken  by  permission  from  Samuel  Untermyer,  “Speculation  on  the  Stock 
Exchange,”  Supplement  to  American  Economic  Review ,  March,  1915,  pp.  47-4S. 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


175 


Concerning  the  profitableness  of  this  type  of  speculation,  no 
authoritative  statement  can  be  made,  as  the  facts  about  success¬ 
ful  attempts  at  manipulation  are  never  made  public,  and  those  con¬ 
cerning  unsuccessful  ones  only  rarely.  The  risks  involved  are  obvi¬ 
ously  large,  but  whether  the  profits  compensate  for  the  risks  undergone 
we  do  not  know. 

Even  the  trader  who  is  correct  in  the  majority  of  his  forecasts  is  likely 
to  lose  more  than  he  makes. — If  all  trades  made  by  a  given  individual 
are  of  the  same  size,  and  he  follows  a  uniform  rule  as  to  the  size  of 
the  profits  or  losses  for  which  he  will  wait  before  closing  out  trades, 
the  odds  against  him  are  small.  Making  trades  purely  at  random, 
the  average  number  of  profitable  trades,  ignoring  commissions  and 
similar  expenses,  would  be  50  per  cent  of  the  total  number  of  trades, 
and  in  the  long  run  the  net  loss  should  therefore  equal  the  total  amount 
of  commissions  and  expenses.  The  average  trader  would  probably  get 
about  the  same  result  by  following  the  news  and  exercising  his 
judgment. 

If  the  trades  are  of  the  “scalping”  type  the  commission  is  a  very 
heavy  percentage  of  the  profit  aimed  at,  and  a  very  large  excess  of 
successes  over  failures  must  be  attained  in  order  to  avoid  speedy  ruin; 
if  the  trader  holds  out  for  five-  or  ten-point  gains  or  losses,  on  the 
other  hand,  a  slight  preponderance  of  successes  will  more  than  offset 
the  commissions  and  other  expenses. 

The  overwhelming  difficulty  is  that  it  is  almost  impossible  to  avoid 
methods  of  trading  which  make  the  average  loss  greater  than  the  aver¬ 
age  gain,  so  that  the  trader  may  be  right  six  or  seven  times  out  of 
ten  and  still  be  forced  to  quit  a  loser.  The  reason  for  this  is  the  incor¬ 
rigible  tendency  to  expand  the  scale  of  operations  after  a  success  and 
to  contract  it  after  a  loss.  Most  speculators  are  supplied  with  small 
capital  in  proportion  to  the  volume  of  their  customary  trades — if  this 
were  not  true  the  privilege  of  trading  on  margin  would  be  of  little 
value,  except  to  the  short  seller.  Suppose  a  speculator  begins  trading 
with  a  capital  of  $2,000,  and  to  be  conservative  decides  to  buy  on  a 
twenty-point  margin  stocks  which  his  broker  would  be  willing  to  carry 
on  ten  points.  He  buys  100  shares  of  Southern  Pacific  stock,  which 
he  sells  at  a  five-point  profit,  clearing  about  $465.  He  repeats  the 
operation,  making  five  and  a  half  points,  and  has  now  increased  his 
capital  to  nearly  $3,000,  and  can  trade  in  150-share  lots  quite  as  safely 
as  he  could  trade  in  100-share  lots  at  first.  Either  by  “pyramiding” 
or  by  collecting  his  profits  and  reinvesting  them  he  can,  so  long  as  all 


176 


RISK  AND  RISK-BEARING 


goes  well,  rapidly  increase  the  scale  of  his  operations  and  correspond¬ 
ingly  increase  the  rate  at  which  his  profits  pile  up.  If  all  his  forecasts 
are  correct,  there  is  no  way  in  which  a  small  capital  can  be  built  up 
into  a  large  one  so  quickly.  But  if  part  of  his  trades  result  in  losses, 
as  they  certainly  will,  the  losses  will  be  sure  to  come  at  the  times 
that  the  trades  are  largest.  On  the  other  hand,  if  the  first  few  trades 
result  in  losses  and  it  becomes  necessary  to  curtail  the  scale  of  opera¬ 
tions,  then  on  the  smaller  scale  of  operations  a  larger  number  of  success¬ 
ful  trades  must  be  made  in  order  to  recover  what  has  been  lost.  If 
the  trades  are  originally  so  large  that  the  trader  is  in  fear  of  being 
sold  out  on  a  decline,  or  if  stop-loss  orders  are  used,  the  probability 
of  making  bigger  average  losses  than  profits  is  accentuated.  In  the 
author’s  opinion,  this  adjustment  of  the  size  of  the  trade  to  the  volume 
of  accumulated  profits  or  losses  is  by  far  the  most  important  cause 
of  the  excessive  proportion  of  losers  among  speculators.  The  only 
real  defense  against  it,  aside  from  avoidance  of  the  market,  is  to  keep 
the  trades  so  small  in  proportion  to  the  capital  actually  used  or  avail¬ 
able  that  the  gain  or  loss  from  an  accidental  succession  of  good  or  bad 
forecasts  will  have  no  appreciable  influence  on  the  scale  of  operations 
which  can  safely  be  undertaken. 

The  probabilities  of  success  in  short-swing  speculation  in  stocks  are 
small. — In  summary  of  our  conclusions  on  this  topic,  it  may  be  said  that 
speculation  in  stocks,  with  a  view  to  profiting  by  fluctuations  in  prices, 
affords  one  of  the  best  examples  of  what  the  economist  calls  entrepre¬ 
neurship,  i.e.,  the  quest  of  pure  profit,  an  income  made  possible  by 
the  presence  of  uncertainty.  The  profit  of  the  successful  enterpriser  in 
this,  as  in  other  forms  of  risk-bearing,  depends  on  the  presence  of  one 
of  three  situations — knowledge  of  the  outlook  superior  to  that  of  others 
who  are  rival  seekers  for  profit  from  the  same  source,  ability  to  control 
the  factors  on  which  the  outcome  of  the  venture  depends,  or  sheer 
superiority  of  luck.  A  few  major  operators  may  have  some  degree 
of  control  over  the  movements  of  the  whole  market,  and  a  consider¬ 
able  number  of  business  men  have  some  control  over  the  prices  of  the 
securities  of  the  corporations  with  which  they  are  connected;  the  rest 
of  the  speculative  fraternity  must  depend  on  knowledge  or  on  luck. 
Of  these,  again,  a  few  have  access  to  “inside  infomation”  which 
enables  them  to  trade  with  the  odds  in  their  favor,  while  the  majority 
must  rely  on  their  superior  sagacity  in  interpreting  the  news  which 
they  share  with  thousands  of  others.  Under  these  circumstances  the 
amount  of  luck  involved  in  the  outcome  of  a  particular  venture  is 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


177 


necessarily  enormous,  and  the  popular  confusion  of  speculation  with 
gambling  has  a  large  degree  of  justification. 

Speculation  for  “ long-swing ”  profits  involves  fewer  unavoidable 
uncertainties  than  does  speculation  for  the  “short-swing  ” — The  opera¬ 
tions  of  the  speculator  who  tries  for  large  profits  on  a  slow  turnover 
are  of  an  entirely  different  character  from  the  type  of  speculation  which 
has  been  discussed  in  the  preceding  pages.  Changes  of  40  or  50  per 
cent  in  the  value  of  the  higher-priced  and  safer  securities,  and  of 
several  hundred  per  cent  in  the  lower-priced  and  more  speculative 
issues,  often  take  place  within  the  course  of  a  year  or  two,  and  traders 
who  successfully  forecast  these  changes  may  make  correspondingly 
large  profits  without  the  futile  and  nerve-wrecking  experience  of  watch¬ 
ing  for  indications  of  the  minor  and  quite  inexplicable  fluctuations 
which  occur  from  day  to  day.  It  is  true,  of  course,  as  in  every  other 
form  of  speculation,  that  it  is  impossible  to  profit  except  by  superior 
luck  or  skill,  that  there  is  always  a  losing  as  well  as  a  winning  side, 
and  that  of  a  large  number  of  trades  the  losses  must  always  exceed 
the  gains  by  the  amount  of  the  commissions,  taxes,  and  other  expenses, 
so  that  there  can  be  no  such  thing  as  a  permanent  science  of  specula¬ 
tion.  As  fast  as  such  a  science  became  generally  known  it  would 
become  obsolete.  In  the  present  stage  of  development  of  the  business, 
however,  it  appears  probable  that  the  fundamental  facts,  which  are 
indeed  accessible  to  all  those  who  put  their  money  into  the  market, 
are  studied  with  care  by  a  sufficiently  small  proportion  of  them  so 
that  there  is  a  fair  chance  that  those  who  do  base  their  opera¬ 
tions  on  something  approaching  the  character  of  a  scientific  study 
will  profit  at  the  expense  of  those  who  do  not.  In  so  far  as  this  is 
true,  it  is  undoubtedly  the  operator  for  the  long  swing  who  has  the 
advantage. 

Analysis  of  the  long-range  outlook  for  security  prices  takes  two 
forms,  namely,  the  study  of  the  outlook  for  individual  firms  and  the 
study  of  the  trend  of  the  market  for  large  groups  of  security  prices. 
Those  who  practice  the  first  type  of  speculation  talk  and  think  in 
terms  of  balance  sheets,  income  statements,  unfilled  orders,  changes  in 
personnel,  and  similar  evidence  of  the  prosperity  and  prospects  of 
individual  firms.  These  are  the  bargain-hunters  of  Wall  Street. 
Their  special  objective  is  to  find  securities  of  relatively  inconspicuous 
corporations  which  have  passed  through  a  period  of  improvement 
whose  effect  on  the  value  of  the  securities  has  been  overlooked,  so 
that  the  securities  may  be  bought  below  their  true  value,  or,  vice 


173 


RISK  AND  RISK-BEARTNG 


versa,  to  find  securities  of  corporations  which  have  a  good  reputation 
based  on  past  performance  but  are  going  backward,  so  that  the  securi¬ 
ties  are  selling  at  a  price  too  high  to  be  justified  by  the  present  outlook. 
Such  traders  have  no  interest  in  safe  bonds  or  stable  stocks  once  the 
public  has  become  convinced  of  their  safety  and  stability. 

The  methods  of  analysis  employed  by  the  bargain-hunting  type 
of  speculator  are  in  general  identical  with  those  employed  by  capital¬ 
ists  who  are  looking  for  a  permanent  investment  for  income.  Espe¬ 
cially  is  the  investor  who  is  trying  to  secure  yields  above  the  market 
rate  for  safe  investments  similar  in  his  objectives  and  methods  to 
the  bargain  hunting  type  of  speculator,  for  the  security  which  con¬ 
tinues  to  yield  an  abnormally  high  return  is  nearly  sure  to  advance 
in  price. 

Investors  for  income,  even  those  who  are  disposed  to  take  specula¬ 
tive  chances  for  the  sake  of  the  high  yield,  characteristically  pay  for 
their  stocks  in  full  and  take  them  out  of  the  market,  while  the  indi¬ 
vidual  who  is  planning  to  close  out  his  trade  on  a  market  fluctuation 
is  very  likely  to  buy  on  a  conservative  margin.  Moreover,  the  long- 
swing  speculator  is  ready  to  take  short  side,  in  case  the  securities  of 
a  given  corporation  are  overvalued,  while  the  investors’  bargains  have 
to  be  found  in  cases  where  the  securities  are  undervalued.  This  differ¬ 
ence  in  methods  of  operation,  however,  does  not  involve  any  important 
difference  in  the  method  of  arriving  at  conclusions  concerning  the 
strength  of  the  corporations  or  the  soundness  of  their  issues. 

Discussion  of  the  methods  used  in  analyzing  the  position  of  indi¬ 
vidual  firms  and  the  strength  of  particular  securities  with  a  view  to 
profiting  by  changes  in  their  prices  is  therefore  deferred  to  chap¬ 
ter  x,  where  attention  is  given  to  the  whole  problem  of  investment 
analysis. 

The  other  type  of  long-swing  speculation  looks  not  at  the  record 
of  the  individual  corporation  but  at  the  future  of  the  market  as  a 
whole.  Followers  of  this  method  talk  and  think  in  terms  of  the 
general  level  of  prices,  the  effect  of  changes  in  the  interest  rate  on 
the  price  of  bonds,  the  amount  of  bank  reserves,  the  volume  of  pig- 
iron  production,  and  similar  “fundamentals.”  For  the  purpose  of 
this  group  of  speculators,  the  most  desirable  stocks  are  those  of 
corporations  whose  prospects  are  the  best  known  and  least  subject  to 
change  from  agencies  peculiar  to  the  corporation  itself.  In  practice 
this  generally  means  the  safer  securities,  not  so  much  because  the 


STOCK  SPECULATION  AS  BUSINESS  ENTERPRISE 


179 


trader  is  averse  to  taking  risks  as  because  these  conservative  securities 
are  most  likely  to  run  “true  to  form”  in  accordance  with  the  outlook 
for  business  activity  and  for  the  money  market. 

This  type  of  speculation  depends  entirely  on  the  principles  dis¬ 
cussed  in  chapter  vi,  hence  needs  no  elaborate  discussion  here.  The 
most  important  barometers  are  those  discussed  in  connection  with  the 
money  market.  The  long-swing  speculator  who  depends  on  this 
type  of  forecasting  keeps  out  of  the  market,  except  as  a  conservative 
investor,  for  perhaps  four-fifths  of  the  time,  returning  to  it  only  when 
he  believes  that  there  are  clear  indications  of  an  early  change  in  the 
trend.  His  plan  is  to  buy  high-grade  preferred  stocks  and  the  very 
best  common  stocks  early  in  a  period  of  liquidation,  shift  to  more 
speculative  securities  late  in  a  depression  and  again  shift  to  short¬ 
term  notes,  or  if  he  is  less  conservative,  take  the  short  side  of  the  specu¬ 
lative  market,  at  the  height  of  a  boom.  Diversification  is  imperative 
in  this  method  of  operation,  as  any  one  security  is  likely  to  fail  to 
follow  the  trend. 

The  greatest  difficulty  in  the  way  of  this  plan,  aside  from  the 
extremely  great  difficulty  in  resisting  the  strong  tide  of  optimism  or 
pessimism  which  sets  against  an  operator  of  this  type,  is  the  fact,  to 
which  reference  was  made  in  chapter  vi,  that  the  swings  of  the  stock 
market  are  more  numerous  than  those  of  the  cycle  of  general  business, 
and  that  there  are  no  known  formulas  for  forecasting  the  intermediate 
swings.  Such  a  decline  as  that  of  1917  is  likely  to  catch  the  student 
of  the  cycle  unprepared. 

The  two  methods  of  long-swing  speculation  are  often  combined. — 
Analysis  of  securities  and  analysis  of  the  trend  of  the  stock  market 
are  distinct  but  not  conflicting  methods,  and  those  who  practice  the 
latter,  as  a  rule,  practice  the  former  also.  That  is,  they  attempt  first 
to  determine  when  to  enter  the  market  either  as  buyers  or  as  sellers, 
then  decide  what  to  buy  or  sell  by  study  of  corporation  reports  and 
the  outlook  for  specific  industries.  Such  bargain-hunting  methods 
presumably  offer  the  largest  chance  of  profit,  but  involve  more  risk 
than  is  involved  in  the  simpler  method  of  sticking  to  the  stocks  of  the 
best-known  corporations  and  depending  on  diversification  for  safety 
and  on  choice  of  times  to  buy  and  sell  as  a  source  of  profit.  The  weak¬ 
ness  of  the  combination  method  is  that  an  error  in  either  the  analysis 
of  the  security  or  the  analysis  of  the  market  will  involve  the  operator 
in  loss. 


i8o 


RISK  AND  RISK-BEARING 


QUESTIONS 

1.  A  bought  ioo  shares  of  stock  on  January  4  at  91  and  sold  on 
February  10  at  94.  Figuring  commissions  at  $25.00,  taxes  at  $4.00  and 
interest  at  5  per  cent,  what  was  his  profit?  How  would  the  profit  be 
affected  by  a  change  of  the  interest  rate  on  90  per  cent  of  the  amount  to 
10  per  cent  ? 

2.  Examine  the  reports  of  the  stock  exchange  trading  in  the  press  and 
list  ( a )  the  explanations  offered  for  market  changes;  ( b )  the  probable 
sources  of  information  in  regard  to  these  reasons. 

3.  Summarize  the  indications  available  to  you  regarding  the  future 
course  of  stock  prices.  Estimate  probable  amount  of  error  in  your  forecast. 


I 


CHAPTER  X 

THE  ANALYSIS  OF  SECURITIES 

As  was  noted  in  chapter  vii,  the  investment  of  capital  in  businesses 
of  others,  or  in  government  securities,  presents  one  of  the  purest  cases 
of  an  economic  activity  in  which  risk  is  the  paramount  consideration 
in  determining  the  course  of  action.  This  is  as  true  of  the  most 
conservative  buyer  of  government  bonds  as  it  is  of  the  most  reckless 
stock-market  operator.  In  each  case,  the  problem  is  exactly  the  same; 
it  is  that  of  judging  the  probability  of  a  favorable  or  an  unfavorable 
outcome,  and  balancing  the  risk  of  loss  against  the  return  to  be  secured 
in  the  event  of  a  favorable  outcome,  in  order  to  determine  which  of 
two  or  more  alternative  employments  of  capital  is  the  more  attractive. 
The  difference  in  the  decisions  of  these  two  extreme  types  of  conserva¬ 
tive  and  reckless  buyers  and  of  the  innumerable  intermediate  types, 
reduces  itself  to  ( a )  a  difference  of  knowledge  of  the  relevant  facts; 
(b)  a  difference  of  judgment  concerning  the  conclusions  to  be  drawn 
from  those  facts;  (c)  a  difference  of  attitude  toward  the  bearing  of  risk. 

The  formulation  of  an  investment  policy  with  regard  to  a  particular 
security  involves  consideration  of  factors  which  may  be  analyzed  as 
follows: 

I.  Income  factors 

a)  The  rate  of  income  yielded 

1.  Direct  yield 

2.  Yield  to  maturity 

b )  Prospective  increases  in  the  rate  of  return 

1.  Changes  in  dividend  rates;  issuance  of  “rights ”;  liquidation  of 
arrears,  etc. 

2.  Prospective  increases  in  market  values 

3.  Gains  through  calling  of  securities  at  premium  above  purchase 
price 

c )  Taxation 

II.  Factors  of  risk 

a)  Security  of  principal 

b )  Certainty  of  income 

c )  Marketability 

d)  Diversification 

III.  Indirect  factors:  control;  prestige;  access  to  desired  information; 

social  and  moral  objections  to  certain  types  of  investment 


181 


182 


RISK  AND  RISK-BEARING 


The  indirect  factors  are  usually  unimportant. — We  may  therefore 
dispose  of  the  third  group  of  considerations  at  once  and  pass  to  those 
which  normally  determine  the  decision.  The  cases  where  the  direc¬ 
tion  of  investment  is  determined  by  collateral  considerations  of  a 
social,  moral,  political,  or  business  nature  are  relatively  few,  are  highly 
diverse  in  character,  and  are  of  so  personal  a  character  that  hardly 
any  important  general  statements  can  be  made  about  them.  In 
theory,  a  type  of  investment  which  is  avoided  by  numerous  investors 
on  account  of  social  and  moral  considerations  must  pay  a  higher  rate 
of  return  to  secure  its  capital,  and  therefore  should  be  unusually  attrac¬ 
tive  to  those  who  are  not  disturbed  by  its  unpopular  aspects,  but 
this  factor  is  of  no  practical  importance,  so  far  as  the  investment 
market  is  concerned.  It  does  have  some  influence  in  determining 
the  rate  of  return  for  personal  services  and  the  profits  of  personally 
conducted  businesses,  but  the  investment  market  is  too  large  and 
impersonal  for  prestige  or  social  disapprobation  to  exert  a  visible 
influence  upon  it. 

The  yields  afforded  by  safe  securities  admit  of  exact  comparison. — 
The  technique  of  methods  of  figuring  direct  and  maturity  yields,  effects 
of  taxation  on  yield,  and  similar  items  with  regard  to  securities 
regarded  as  safe  needs  no  discussion  here.  These  are  questions  of 
mathematics,  not  of  business  judgment,  and  are  fully  treated  in  the 
general  literature  of  investment  as  well  as  in  that  of  mathematics.1 

The  essence  of  the  problem  of  relating  price  to  yield,  where  risk 
is  disregarded,  is  a  comparison  between  the  present  and  the  future 
value  of  a  stated  sum  of  money.  The  market  value  of  a  safe  security 
is  the  sum  of  the  present  worths  of  all  the  amounts  to  be  received — 
principal,  interest,  dividends,  rights,  premiums,  etc.,  discounted  at  the 
market  rate  of  interest,  and  conversely  the  yield  is  the  rate  of  interest 
at  which  the  market  price  compounded  will  amount  to  the  various 
sums  payable  under  the  instrument  by  the  time  they  are  due  and  paid. 
In  the  case  of  securities  which  pay  normal  rates  of  interest  at  ordinary 
intervals,  the  investor  is  relieved  of  the  labor  of  calculation  through 
the  use  of  bond  tables,  while  for  irregular  payments  formulas  are 
available  which  make  the  calculation  purely  mechanical.2 

1  See,  for  example,  Lagerquist,  Investment  Analysis;  Chamberlain,  Principles 
of  Bond,  Investment ;  Jordan,  Investments;  Skinner,  Mathematics  of  Investment. 

2  The  use  of  these  tables  and  formulas  involves  certain  elements  of  error,  none 
of  which,  however,  are  of  great  practical  importance.  The  inaccuracies  include 
the  following :  (a)  Loss  of  interest  on  interest  accrued  at  the  time  of  investment:  The 


THE  ANALYSIS  OF  SECURITIES 


183 

Tax  exemptions,  so  far  as  they  are  known  when  investments  are 
made,  involve  a  simple  modification  of  the  mathematical  results  of 
calculations  of  yield.  They  would  be  of  no  practical  importance  if 
they  affected  all  investments  alike,  since  the  problem  is  always  one 
of  a  choice  between  alternative  employments  of  capital,  but  if  these 
are  differently  affected  by  taxation  the  difference  may  be  of  very 
great  importance.  This  is  particularly  likely  to  be  true  if,  as  at  present 
in  the  United  States,  the  same  security  or  income  is  taxed  differently 
in  the  hands  of  different  holders.  Thus  to  an  individual  who  pays 
surtax  at  a  high  rate  on  his  income,  a  fully  tax-exempt  bond  bearing 
5  per  cent  interest  is  more  attractive  than  a  6  per  cent  security  with¬ 
out  the  exemption,  while  the  small  investor  would  suffer  a  loss  if  he 
selected  the  higher-priced  security.* 1 


purchase  price  of  bonds  usually  includes  a  pro  rata  share  of  the  next  instalment  of 
interest;  on  this  amount  the  investor  loses  interest  until  it  is  repaid  at  the  next 
interest  date.  This  results  in  a  lowering  of  the  actual  yield,  unless  the  securities 
are  purchased  on  interest  dates.  The  discrepancy  is  greatest  if  purchases  are  made 
at  a  time  midway  between  interest  dates,  (b)  Decimal  approximation:  The  bond 
tables  ordinarily  used  give  interest  yields  accurate  to  the  second  decimal  place. 
The  maximum  error  which  can  result  from  this  is  $5.00  per  $100,000  of  principal 
in  figuring  interest  for  one  year.  Tables  are  available,  however,  which  give  results 
accurate  to  the  cent  for  sums  up  to  $1,000,000.  (c)  Rate  of  interest  earned  by 

reinvestment  of  amortization  funds:  Bond  tables  are  constructed  on  the  assumption 
that  the  payments  to  amortize  the  premium  or  discount  are  invested  at  the  same 
rate  as  the  yield  on  the  security  itself;  this  assumption  is  likely  to  be  inaccurate. 
(d)  Time  of  reinvestment:  This  error  is  similar  to  the  one  just  mentioned.  The 
tables  assume  that  all  payments  in  amortization  of  premium  or  discount  are  rein¬ 
vested  instantaneously;  this  is  often  impracticable,  (e)  Interest  interval:  The 
assumption  of  thi  tables  is  that  the  amortization  payments  will  earn  interest  pay¬ 
able  semiannually;  if  interest  is  collected  quarterly  or  annually  a  slight  error 
results.  (Cf.  Chamberlain,  op.  cit.,  pp.  412-22.) 

1  In  this  connection,  it  may  not  be  out  of  place  to  refer  to  the  widespread 
fallacy  that  tax  exemptions  create  a  scarcity  of  capital  for  enterprises  which  can¬ 
not  issue  similarly  tax-exempt  securities,  a  fallacy  which  has  recently  appeared  in 
highly  respectable  financial  literature.  Tax  exemptions  make  a  security  less 
attractive  to  some  investors  and  more  attractive  to  others,  but  the  financing 
of  public  enterprises  through  tax-exempt  securities  makes  no  larger  drain  on  the 
capital  resources  of  the  country  than  would  the  financing  of  the  same  enterprises 
through  securities  subject  to  taxation.  The  tendency  of  tax  exemption  is  to  , 
bring  about  a  concentration  of  the  securities  so  favored  in  fewer  hands  than 
would  otherwise  be  the  case,  but  unless  it  is  believed  that  the  public  enterprises 
for  which  they  are  issued  would  not  be  financed  at  all  without  the  exemptions 
it  cannot  be  said  that  they  operate  to  reduce  the  amount  available  for  other  en¬ 
terprises,  or  to  increase  the  rate  other  enterprises  must  pay  for  their  capital. 
This  statement  is  subject  to  a  slight  modification  on  account  of  the  greater 
selling  cost  involved  in  securing  capital  from  the  small  investors  to  whom  taxable 
securities  are  most  valuable. 


184 


RISK  AND  RISK-BEARING 


Prospective  changes  in  income,  which  are  placed  among  the  factors 
of  income  in  our  outline,  may  belong  either  here  or  in  the  category  of 
risk  factors,  in  accordance  with  the  degree  of  certainty  of  their  attain¬ 
ment.  Future  changes  in  dividend  rates  or  in  bond  interest  rates, 
the  payment  of  accrued  interest  or  instalments  of  principal,  and  other 
changes  in  nominal  returns,  if  they  are  certain,  are  taken  account  of 
in  figuring  the  yield  or  price  at  the  time  an  investment  is  made,  just 
as  are  the  regular  rate  of  interest  and  the  amortization  of  the  discount 
or  premium  on  bonds.  These  payments  involve  no  element  of 
income  to  the  investor,  except  the  accrual  of  discount  which  was 
contemplated  in  the  original  price.  On  the  other  hand,  prospective 
changes  in  income,  whether  increases  or  decreases,  which  are  not* 
regarded  as  certain,  enter  into  the  investor’s  decisions  as  part  of  the 
factor  of  risk.  Premiums  on  redemption,  profits  on  resale,  gains  at 
maturity,  and  other  irregular  items,  both  certain  and  uncertain,  come 
into  the  calculation  in  exactly  the  same  way  as  do  the  ordinary  pay¬ 
ments  of  dividends  or  interest.  In  each  case,  an  income  in  the  nature 
of  interest  arises  from  a  discounting  of  the  payments  anticipated  as 
certain,  while  economic  profit  or  loss  arises  from  the  items  not  fore¬ 
known  and  hence  not  fully  discounted  in  the  market  price  at  the 
time  of  purchase.  The  only  difference  is  that  the  irregular  items  are 
less  likely  to  be  foreknown. 

Let  us  consider  next  the  factors  of  risk.  Security  of  principal  and 
stability  of  income  are  very  closely  related.  In  theory,  in  many  types 
of  security,  the  safety  of  the  principal  depends  on  the  value  of  property 
specifically  or  impliedly  pledged  for  the  purpose,  while  income  is  more 
directly  dependent  upon  the  earning  power  of  the  issuing  organization. 
Practically,  however,  the  distinction  is  rarely  important.  The  value 
of  property  depends  upon  its  income-producing  power,  and  in  default 
of  earnings  or  other  income  out  of  which  to  meet  interest  payments, 
asset  values  crumble  away.  In  choosing  between  ample  property 
values  and  ample  earnings,  the  latter  should  always  be  given 
preference. 

When  the  safety  of  principal  and  income  in  any  investment  is  so 
great  as  to  be  a  matter  of  general  agreement,  the  yield  is  nearly  sure 
to  be  low,  but  there  are  cases  where  by  careful  study  and  good  judg¬ 
ment  an  income  can  be  secured  in  excess  of  that  usually  obtainable 
on  securities  of  similar  strength.  This  is  the  chief  object  of  invest¬ 
ment  analysis.  Success  in  identifying  such  opportunities  affords 
opportunity  not  only  for  profit  in  the  form  of  an  income  yield  in 


THE  ANALYSIS  OF  SECURITIES 


1^5 

excess  of  interest  and  replacement  funds,  but,  also  for  profit  from 
increase  of  market  values,  for  securities  rarely  remain  distinctly 
undervalued  for  long  periods  of  time. 

Marketability  is  the  facility  with  which  a  security  can  be  bought 
or  sold.  Since  it  is  nearly  always  possible,  however,  to  buy  or  sell 
a  security  of  known  income-producing  quality  at  some  price,  the 
concept  of  marketability  has  been  extended  to  mean  the  facility  with 
which  the  security  in  question  can  be  bought  or  sold  at  a  reasonable 
price.  The  best  test  of  reasonableness  in  price  is  the  “spread”  or 
difference  between  what  the  investor  can  probably  get  if  he  tries  to 
secure  a  quick  sale  and  the  price  he  would  have  to  pay  to  obtain 
additional  securities  of  the  same  type.  Marketability  is  largely  a 
question  of  the  size  of  the  holdings.  For  the  small  investor,  there 
are  innumerable  high-grade  securities  of  attractive  yield  which  have 
a  “close”  market  for  the  small  units  in  which  he  is  interested,  but 
there  are  very  few  securities  which  can  be  bought  or  sold  in  very  large 
quantities  without  forcing  the  price  materially  upward  or  downward. 
Quotations  for  listed  securities,  and  for  those  unlisted  securities  in 
which  there  is  sufficient  trade  to  maintain  a  quotable  market,  are  the 
prices  at  which  small  lots — usually  one  hundred  shares  in  stocks  and 
$1,000  in  bonds — are  changing  hands,  and  may  be  entirely  misleading 
if  used  as  indices  of  the  marketability  of  large  lots.  Quotations  for 
new  securities  which  are  in  process  of  distribution  are  particularly 
deceptive,  because  such  securities  are  regularly  supported  by  standing 
bids  from  the  distributing  houses  at  the  issue  price.  This  gives  the 
market  the  appearance  of  being  very  close  and  active.  Investors  who 
buy  bonds  in  reliance  on  these  quotations  as  an  assurance  of  their 
ability  to  recover  their  capital  at  will  are  likely  to  find  at  a  later  time 
that  the  quoted  market  has  disappeared  and  that  the  only  outlet  for 
the  securities  is  through  the  distributing  house.  Such  houses  usually 
do  protect  their  customers  by  making  a  market  over  their  own  coun¬ 
ters,  so  that  their  issues  are  much  more  marketable  than  those  of 
corporations  which  do  their  own  financing  or  those  marketed  by 
irresponsible  and  transient  underwriters. 

Marketability  is  of  importance  for  the  investor  who  is  attentive 
to  the  security  market  and  wishes  to  shift  his  funds  from  one  invest¬ 
ment  to  another  as  the  relative  desirability  of  different  issues  changes. 
It  is  also  of  importance  in  case  all  or  part  of  the  invested  funds  are 
likely  to  be  needed  for  personal  support  or  for  strengthening  the 
finances  of  a  private  business.  Marketability,  as  was  noted  above,1 

1  See  p.  123. 


RISK  AND  RISK-BEARING 


186 

is  a  device  to  give  the  investor  protection  against  the  risk  of  being 
unable  to  recover  his  funds  when  he  wants  them,  without  creating 
for  the  borrower  a  corresponding  risk  of  being  called  on  to  repay  them 
at  an  inconvenient  time.  For  most  investors,  it  is  highly  desirable 
to  have  some  funds  in  marketable  securities,  but  a  waste  of  money  to 
pay  for  this  advantage  for  all  one’s  funds.  Sometimes  the  cost  is 
negligible,  however.  The  two  principal  devices  for  securing  market¬ 
ability  are,  first,  the  exchanges,  and,  second,  the  practice  of  invest¬ 
ment  banks  of  maintaining  a  market  for  securities  which  they  have 
floated.  So  well  developed  are  these  and  other  marketing  agencies 
that  the  mere  fact  of  a  high  degree  of  safety,  coupled  with  attractive 
income  yield,  is  now  usually  sufficient  to  insure  marketability  in  the 
case  of  so  many  of  the  investments  that  no  one  need  pay  a  high  price 
to  secure  the  necessary  liquidity  in  his  funds.  The  two  types  of 
investment  where  this  is  least  likely  to  be  true  are  small  real  estate 
mortgages  and  the  securities  of  little-known  corporations  which  have 
been  sold  without  the  intervention  of  an  investment  banker.  In 
these  cases,  it  may  readily  be  true  that  the  risk,  as  estimated  by  those 
best  informed,  is  very  small,  while  at  the  same  time  the  market  is  so 
restricted  by  the  difficulty  of  obtaining  this  information  that  the 
security  will  lose  much  of  its  attractiveness  for  those  who  wish  to  keep 
their  funds  mobile.  In  such  cases,  the  income  return  is  likely  to  be 
high  as  compared  to  the  risk  of  final  loss,  and  the  security  correspond¬ 
ingly  attractive  to  those  who  know  the  facts  and  do  not  require 
marketability  in  their  investments. 

The  analysis  of  securities,  to  determine  the  degree  of  risk  attendant 
upon  their  purchase,  presents  a  problem  of  considerable  difficulty,  and 
one  which  differs  greatly  in  character  with  respect  to  different  types 
of  security.  So  many  legal,  personal,  and  technical  elements  in  the 
solution  are  inaccessible  to  the  individual  private  investor  that  he  is  * 
compelled  to  rely  in  large  part,  no  matter  how  careful  his  own  analysis, 
upon  the  findings  of  experts.  Nevertheless,  a  knowledge  of  the  ele¬ 
ments  of  the  method  to  be  employed  is  necessary,  if  for  no  other  purpose 
than  to  assist  in  the  choice  of  counsel.  The  case  is  not  dissimilar 
to  the  case  for  training  in  law  as  an  aid  to  the  business  man.  A  lay¬ 
man’s  training  in  law  cannot  serve  as  a  substitute  for  the  services  of  a 
good  lawyer,  but  it  may  be  very  useful  as  a  means  of  aiding  him  to 
decide  when  the  lawyer’s  services  are  really  needed,  and  as  a  guide 
in  distinguishing  the  trustworthy  adviser  from  the  charlatan.  It  is 
true  in  the  investment  field,  even  more  than  in  the  furnishing  of  legal 


THE  ANALYSIS  OF  SECURITIES 


187 


advice,  that  high  respectability  and  pretentious  claims  of  expertness 
and  disinterestedness  cannot  be  taken  at  face  value.  A  little  learning 
is  a  dangerous  thing,  but  it  is  quite  sufficient  to  unmask  the  emptiness 
of  the  claims  of  a  large  proportion  of  bond  salesmen  to  a  standing  as 
expert  advisers. 

For  discussion  of  methods  of  analysis,  the  bulk  of  investment 
securities  may  be  classified  as  follows:  (a)  United  States  government 
and  municipal  bonds;  ( b )  foreign  government  bonds;  (c)  railroad 
bonds  and  stocks;  (d)  public  utility  bonds  and  stocks;  (e)  industrial 
bonds  and  stocks. 

Concerning  the  obligations  of  the  United  States  government, 
those  of  most  of  the  states,  of  the  federal  land  banks,  and  of  many  of 
the  municipalities  of  the  country,  the  question  of  safety  is  hardly 
worth  discussion.  Conditions  under  which  they  would  be  defaulted 
or  become  unmarketable  are  quite  thinkable,  but  they  are  conditions 
so  remote  that  we  have  no  means  of  forecasting  their  approach,  and 
no  way  of  selecting  alternative  employments  of  capital  which  are 
free  from  the  same  elements  of  risk.  The  fluctuations  in  the  value  of 
these  securities  depend  on  variations  in  the  interest  rate  at  which  the 
payments  are  capitalized,  not  on  factors  of  risk  at  all.  The  choice 
among  these  investments  rests  chiefly  on  considerations  of  taxation. 
Some  are  completely  exempt  from  all  taxes,  others  have  exemptions 
restricted  either  to  holders  of  limited  quantities  or  to  residents  in 
states  in  which  they  are  issued.  These  exemptions  make  them  so 
much  more  valuable  than  securities  not  so  exempt,  to  a  small  group 
of  holders,  that  others  frequently  cannot  buy  them  at  a  price  where 
they  are  as  attractive  as  are  safe  securities  without  the  exemption 
feature. 

In  the  case  of  most  bonds  of  political  subdivisions  of  the  American 
states,  the  factor  of  safety  is  very  high,  but  more  caution  is  necessary 
in  purchasing  them  than  is  the  case  with  the  issues  of  the  United  States 
and  of  the  states  themselves.  The  questions  which  arise  in  connec¬ 
tion  with  them  relate  themselves,  first,  to  validity;  second,  to  legal 
limitations  on  the  power  to  incur  additional  debt;  third,  to  financial 
strength  compared  with  the  outstanding  debt;  and  fourth,  to  character 
of  the  community. 

The  legal  questions  which  arise  in  connection  with  municipal  bond 
issues  are  so  technical  as  to  make  it  very  difficult  and  expensive  for 
the  individual  investor  to  satisfy  himself  in  regard  to  them;  hence, 
except  in  the  case  of  small  issues  which  are  issued  locally,  recourse  is 


RISK  AND  RISK-BEARING 


1 88 

had  to  the  intervention  of  an  investment  house  which  buys  and  dis¬ 
tributes  the  issue,  giving  its  customers  the  benefit  of  opinion  of  its 
legal  counsel.  This  method  enables  all  of  the  issue  to  be  sold  to 
scattered  investors  on  the  faith  of  one  investigation,  and,  except  in 
the  case  of  the  largest  buyers,  it  is  the  only  method  which  is  at  all 
practicable.  To  a  certain  extent,  the  same  method  is  applicable  to 
other  phases  of  the  investigation.  The  financial  middleman  takes 
the  responsibility  of  collecting  the  data  relative  to  financial  resources, 
existing  debt,  limitations  on  further  debt,  purposes  of  the  issue,  etc., 
and  assembles  them  in  a  convenient  prospectus  for  the  information 
of  the  investor.  It  is  possible,  however,  for  the  investor  to  check  up 
on  some  of  these  details,  and  probably  rather  better  worth  while  that 
he  should  do  so  than  is  the  case  with  the  questions  of  legality  and 
validity.  So  far  as  outright  misstatement  is  concerned,  the  prospectus 
of  a  reliable  investment  house  is  presumed  to  be  trustworthy,  for  the 
ethics  of  the  business  set  a  high  standard  of  accuracy,  but  there  is 
more  likelihood  of  omission  of  significant  qualifying  detail  than  is  the 
case  with  the  opinion  of  counsel  concerning  legal  requirements  sur¬ 
rounding  the  issue.  For  example,  it  is  not  infrequently  the  case  that 
the  amount  of  debt  per  capita  or  per  dollar  of  assessed  valuation  of  a 
given  political  district  is  stated  without  reference  to  the  fact  that  the 
same  population  or  property  is  included  within  the  bounds  of  over¬ 
lapping  or  coextensive  units  which  have  independent  debts,  or  author¬ 
ity  to  contract  them. 

Foreign  government  bonds  have  only  recently  come  to  occupy  a 
large  share  of  the  attention  of  the  American  investing  public.  Under 
pre-war  conditions,  the  securities  of  the  leading  nations  of  the  world 
shared  the  distinction  of  rating  as  riskless  securities.  The  effect  of 
the  war  has  been  to  destroy  the  credit  of  certain  nations  whose  securi¬ 
ties  formerly  enjoyed  this  high  rating,  and  to  inject  an  appreciable 
amount  of  uncertainty  into  the  status  of  others  whose  credit  is  still 
high.  It  has  also  had  the  effect  of  shaking  confidence  in  the  absolute 
soundness  of  the  bonds  of  countries  which  were  not  adversely  affected 
by  the  war,  by  emphasizing  the  uncertainty  of  the  political  structure 
of  modern  civilization  which  underlies  the  value  of  the  whole  body  of 
evidences  of  public  debt  of  most  countries  whose  securities  enter  the 
investment  market. 

In  all  probability,  there  is  no  considerable  group  of  securities 
in  existence  whose  record  of  payment  of  the  interest  and  principal 
of  their  bonded  debt  is  as  likely  to  be  unbroken,  which  yet  yield 


THE  ANALYSIS  OF  SECURITIES 


189 


as  high  a  return  as  the  obligations  of  the  neutral  and  former 
allied  nations  of  Western  Europe.  Analysis  in  accordance  with  the 
usual  methods  of  comparison  of  indebtedness,  financial  resources,  and 
record  of  performance  of  obligations  in  the  past,  entitles  them  to  the 
very  high  rating  which  they  are  accorded  by  professional  financial 
rating  bodies.  Yet  the  market’s  rating  is  unfavorable,  and  the  reluc¬ 
tance  of  investors  to  register,  in  actual  purchases,  the  high  rating  which 
paper  analysis  affords,  is  not  difficult  to  understand.  The  major  risk 
in  the  investment  of  capital  in  the  securities  of  the  nations  of  Western 
Europe  is  the  hazard  of  another  great  war,  and  this  hazard  is  entirely 
incapable  of  mathematical  estimate  either  as  to  the  probability  of  its 
incidence  or  as  to  its  probable  effect  upon  the  foreign  bonds  of  the 
countries  engaged  in  it.  It  seems  highly  probable  that  the  course  of 
events  over  the  next  decade  or  two  will  be  such  as  to  strengthen  the 
credit  rating  of  all  the  leading  powers;  and  if  so,  the  yields  of  their 
foreign  debt  at  this  time  will  seem  a  few  years  hence  to  have  been 
incredibly  high.  It  does  not  on  the  other  hand  seem  impossible 
that  international  war,  or  internal  disturbance,  may  reduce  the  obli¬ 
gations  of  other  powers  to  the  status  of  the  bonds  of  Germany  and 
Russia;  the  proper  bond  yield  to  discount  this  possibility  is  a  matter 
of  conjecture  rather  than  of  investment  science. 

In  the  analysis  of  corporate  securities,  the  same  contrast  appears 
which  we  noted  in  the  analysis  of  municipal  issues,  between  the  items 
which  the  individual  investor  can  learn  and  discount  for  himself  and 
the  items  in  regard  to  which  he  is  dependent  on  the  specialized  assist¬ 
ance  of  the  investment  banker  or  other  financial  specialist.  There  is 
this  important  difference,  however,  that,  in  the  case  of  the  industrial 
issues,  the  legal  questions  are  relatively  of  less  importance,  and  the 
general  economic  and  financial  factors  which  are  accessible  to  the 
investor  for  use  in  forming  an  independent  judgment  are  more  numer¬ 
ous  and  more  important,  so  that  detailed  examination  of  the  problems 
which  confront  him  is  more  likely  to  be  of  practical  value.  This  is 
the  more  important  because  the  services  of  the  financial  middleman 
are  available  chiefly  in  connection  with  new  issues,  while  many  of  the 
issues  concerning  which  the  investor  has  an  interest,  are  old  issues 
which  are  no  longer  being  pushed  systematically  by  any  financial 
organization. 

The  following  outline  suggests  the  most  important  items  which 
should  be  taken  into  account  in  estimating  the  investment  position 
of  the  securities  of  industrial  corporations: 


190 


RISK  AND  RISK-BEARING 


ELEMENTS  OF  STRENGTH  IN  INDUSTRIAL  SECURITIES 

I.  Position  of  the  industry 

a )  Secular  trend:  Is  the  business  likely  to  increase  or  decrease  in 
importance  ? 

b)  Cyclical  position:  How  is  this  line  of  business  affected  by  the 
coming  and  going  of  prosperity  ? 

II.  Position  of  the  individual  firm 

a)  Position  in  the  industry 

1.  Strength  of  competition,  present  and  prospective 

2.  Record  of  growth;  evidence  of  progressive  policy 

3.  Reputation  of  firm  in  the  industry 

b)  Financial  position 

1.  Current  position 

2.  Financial  history 

3.  Banking  and  underwriting  connections 

c )  Personnel 

III.  Position  of  the  individual  securities 

a)  Priority  of  lien;  adequacy  of  security;  protective  provisions 

b)  Market  history 

c )  Technical  factors:  floating  supply,  market  interest,  manipulative 
activity,  etc. 

The  position  of  the  industry  is  usually  susceptible  of  more  adequate 
analysis  than  is  the  position  of  the  individual  firm.  Industries  rise 
and  decay  as  do  individual  firms.  The  most  profitable  investments 
have  been  those  which  have  been  made  at  an  earlier  stage  in  the  history 
of  a  new  and  successful  invention.  It  does  not  follow  however  that 
a  policy  of  seeking  such  opportunities  is  a  profitable  policy.  For 
every  case  where  fortunes  have  been  made  by  buying  the  securities  of 
corporations  formed  to  develop  new  industries,  dozens  of  ventures, 
which  at  the  outset  appeared  equally  promising,  have  swallowed  the 
capital  of  their  projectors  without  adequate  return.  The  history  of 
the  telephone,  the  telegraph,  and  the  condensed-milk  industry  is 
constantly  kept  fresh  in  the  minds  of  investors  by  promoters  of  new 
concerns,  while  the  financial  failure  of  liquid  air  quickly  fades  from 
memory,  Even  where  new  industries  have  been  successful  in  the  end, 
it  is  frequently  true  that  the  original  investors  have  failed  of  a  reward, 
or  that  the  major  returns  have  gone  to  those  who  came  to  the  rescue 
of  the  enterprise  when  it  had  passed  its  initial  difficulties  but  exhausted 
its  capital  in  so  doing.1 

1  Cf.  Conyngton,  Financing  an  Enterprise,  chaps,  xii,  xiii. 


THE  ANALYSIS  OF  SECURITIES 


191 

On  the  other  hand,  the  fact  that  an  industry  has  a  long  and  impres¬ 
sive  record  of  profitable  operations  is  not  sufficient  to  make  it  a  desir¬ 
able  field  for  the  investment  of  additional  capital,  or  even  for  the 
purchase  of  securities  representing  investment  already  made.  The 
price  at  which  such  securities  are  obtainable  is  usually  controlled, 
among  other  things,  by  the  past  record  of  the  industry,  and  if  the 
industry  has  passed  its  zenith,  investments  in  it  are  likely  to  be  over¬ 
valued.  This  is  true  not  only  of  cases  where  the  market  for  its  output 
is  actually  dwindling  but  also  of  the  less  obvious  cases  where  the  rate 
of  growth  is  falling  or  is  generally  overestimated,  so  that  an  overbuilt 
condition  threatens.1 

If  the  growth  of  an  industry  has  been  determined  in  part  by  the 
development  of  a  consumers’  fad,  as  was  the  case  with  the  bicycle 
industry  in  the  middle  nineties  and  the  radio  industry  in  1922,  there 
is  no  accurate  method  of  forecasting  its  development.  Collapses, 
due  to  the  appearance  of  a  superior  technique  of  production  or  the 
invention  of  substitute  products  of  superior  efficiency  or  lower  cost, 
are  also  impossible  to  foresee.  They  are  among  the  inherent  risks  of 
industry,  which  can  readily  be  seen  to  be  greater  in  some  industries 
than  in  others,  but  cannot  be  eliminated  by  research. 

The  decline  in  profitableness  which  results  from  an  overbuilt 
condition,  however,  can  frequently  be  foreseen.  Statistics  of  con¬ 
sumption  of  basic  commodities  for  the  leading  countries  are  available, 
and  the  producing  capacity  of  most  industries  is  also  a  matter  of 
approximate  knowledge.  During  a  time  of  prosperity,  whether  the 
general  prosperity  which  marks  the  culmination  of  an  upward  swing 
of  the  business  cycle  or  a  boom  in  a  specific  industry  caused  by  war 
orders,  by  a  consumers’  craze,  or  by  the  development  of  new  markets 
for  the  product,  there  is  always  great  danger  that  an  overinvestment 
will  take  place.  The  result  of  such  a  contingency  is  not  merely  to 
waste  the  capital  of  those  investors  who  come  in  last  or  choose  the 
least  favorable  conditions  for  their  investment;  it  is  often  to  create 
a  condition  of  overcompetition  which  makes  it  difficult  for  any  concern 
in  the  industry  to  make  satisfactory  returns  on  its  capital. 

In  general,  investments  in  the  securities  of  corporations  which 
have  monopolistic  advantages  are  the  safest,  and  those  in  industries 
where  competition  is  keen  are  the  riskiest.  Competition  has  decided 
advantages  from  the  standpoint  of  protection  of  the  public  interest, 
but  monopoly  has  correspondingly  great  advantages  from  the  stand- 

£  Cf.  J.  M.  Clark,  quoted  above,  pp.  79-81. 


192 


RISK  AND  RISK-BEARING 


point  of  investors.  This  applies  not  only  to  those  concerns  which  are 
protected  by  patents  or  franchises  or  by  control  of  limited  natural 
resources.  Indeed,  it  is  often  the  case  that  such  corporations  are 
singled  out  as  the  subjects  of  attack  by  legislators  and  by  the  agencies 
which  shape  public  opinion  to  such  an  extent  as  greatly  to  lessen  the 
strength  of  their  position.  If  this  is  not  the  case,  the  price  to  be  paid 
for  their  securities  is  likely  to  discount  the  strength  of  their  position 
so  that  the  investor  secures  a  safe  investment,  but  one  which  yields 
a  correspondingly  low  return.  Almost  as  high  a  degree  of  safety,  with¬ 
out  so  much  danger  of  attack,  and  often  without  the  necessity  of  pay¬ 
ing  so  high  a  price  for  it,  is  obtainable  through  investment  in  securities 
of  concerns  which,  without  possessing  actual  monopoly  power,  yet 
have  attained  such  a  position  of  leadership,  either  through  early 
start,  unusually  competent  management,  high  reputation  of  product, 
or  successful  advertising,  as  to  render  them  relatively  free  from  the 
effects  of  competition.  The  advantage  which  such  concerns  enjoy  is 
particularly  apparent  in  periods  of  liquidation  and  depresssion.  At 
such  times,  competition  in  most  lines  is  abnormally  keen,  so  that  even 
those  concerns  which  secure  a  satisfactory  volume  of  orders  find  it 
impossible  to  make  a  good  margin  of  profit,  but  the  concerns  which 
are  fortunate  enough  to  have  a  position  of  monopoly  or  semi-monopoly, 
though  they  suffer  a  decline  in  the  volume  of  orders  received,  are  able 
to  keep  prices  at  a  level  which  insures  a  satisfactory  profit  on  the  busi¬ 
ness  actually  done. 

Industries  differ  widely  in  the  extent  to  which  their  volume  of 
business  and  their  profit  margins  are  affected  by  the  business  cycle. 
It  is  not  necessarily  true  that  an  industry  in  which  there  are  violent 
fluctuations  of  prosperity  and  depression  is  for  that  reason  either  more 
or  less  profitable  than  a  steadier  industry,  but  it  is  necessary  to  take 
careful  account  of  this  factor  in  appraising  the  financial  record  of  the 
individual  concern  for  two  reasons.  In  the  first  place,  the  securities 
of  corporations  engaged  in  lines  where  the  fluctuation  is  great  are  to  a 
considerable  extent  valued  upon  the  basis  of  the  immediate  outlook, 
rather  than  upon  the  average  of  good  and  bad  times  which  determines 
their  real  income-producing  power.  Hence  they  are  very  likely  to 
be  overvalued  in  good  times  and  undervalued  in  bad  times,  and  the 
investors’  decisions  should  be  made  with  this  factor  in  mind.  In  the 
second  place,  many  industrial  corporations  and  not  a  few  underwriting 
concerns  are  not  overscrupulous  about  choosing  financial  data  in 
such  a  way  as  to  make  the  best  possible  showing  for  the  concern. 


THE  ANALYSIS  OF  SECURITIES 


193 


Hence,  prospectuses  which  advertise  securities  on  the  basis  of  the  aver¬ 
age  earnings  for  the  preceding  three  or  five  years,  or  the  balance 
sheet  at  a  given  time,  should  be  scrutinized  with  care  to  see  whether 
they  represent  the  showing  during  an  abnormally  favorable  period 
of  the  business  cycle. 

The  extent  to  which  a  given  industry  is  subject  to  the  influence 
of  cyclical  movements  depends  chiefly  on  the  character  of  the  product. 
Consumption  goods  are  affected  quite  differently  from  producers’ 
goods.  Among  consumers’  goods,  the  demand  for  luxuries  fluctuates 
more  than  that  for  necessities,  but  even  so-called  necessities  show 
plainly  the  effect  of  changes  in  income  which  result  from  prosperity 
and  depression.  More  important  is  the  classification  into  goods  which 
make  up  a  significant  part  of  the  budget  and  those  which  are  trifling 
in  importance  from  the  standpoint  of  the  amount  spent  by  any  one 
user.  Matches,  for  instance,  show  much  less  evidence  of  the  cycle 
in  their  market  than  does  meat,  though  a  proportionate  reduction  in 
the  consumption  of  matches  would  probably  involve  much  less  real 
sacrifice  for  the  community. 

Producers’  goods  fluctuate  in  demand  with  the  demand  for  the 
product,  but  this  fluctuation  is  greatly  accentuated  in  certain  lines  by 
the  producers’  practice  of  specializing  in  the  manufacture  of  parts  and 
supplies  for  the  use  of  other  manufacturers  who  produce  themselves 
enough  to  supply  part  of  their  needs.  In  case,  for  instance,  a  manu¬ 
facturer  of  automobiles  is  equipped  to  produce  a  certain  part  in 
sufficient  quantity  to  supply  his  needs  when  his  plant  is  running  at 
half-capacity,  a  decline  in  his  business  from  100  per  cent  to  75  per 
cent  of  capacity  will  result  in  a  reduction  of  about  50  per  cent  in  his 
purchases,  assuming  that  he  does  not  produce  or  purchase  for  stock, 
and  a  50  per  cent  reduction  in  the  volume  of  his  orders  will  take  him 
out  of  the  market  as  a  buyer  entirely. 

Still  more  important,  in  many  cases,  is  the  question  of  perisha¬ 
bility  of  product.  If  it  is  possible  to  store  up  a  product  for  future  use 
or  sale  at  times  when  scarcity  or  rising  prices  are  expected,  the  fluctua¬ 
tions  in  actual  consumption  will  be  greatly  exaggerated  in  the  market 
demand  for  the  product.  For  example,  the  demand  for  bread  shows 
little  effect  of  the  cycle,  but  that  for  flour  shows  it  very  clearly. 

Another  important  point  is  the  readiness  with  which  prices  of  the 
commodity  or  service  sold  reflect  changes  in  market  conditions.  Lines 
in  which  selling  prices  are  fixed  by  law  or  custom  have  a  cycle  of  pros¬ 
perity  inverse  to  that  of  most  businesses,  their  costs  going  up  in  times  of 


194 


RISK  AND  RISK-BEARING 


prosperity  more  than  their  incomes,  and  vice  versa.  Gold-mining  and 
the  manufacture  of  artificial  gas  are  illustrations.  This  point  is  of 
importance  not  only  in  connection  with  the  securities  of  corporations 
engaged  in  these  industries  but  also  in  judging  the  position  of  industries 
which  sell  them  equipment  and  supplies.  Manufacturers  of  electrical 
equipment  are  relieved  of  part  of  the  effect  of  the  business  cycle  by 
the  fact  that  their  sales  to  public  utilities  are  likely  to  increase  at  times 
when  their  sales  to  industrial  concerns  are  at  a  minimum. 

Analysis  of  the  financial  position  of  industrial  corporations  always 
involves  a  large  margin  of  error. — Whereas  the  facts  concerning  the 
present  condition  and  outlook  for  whole  industries  are  in  large  part 
common  knowledge  so  far  as  they  are  available  to  anyone,  the  facts 
concerning  the  position  of  individual  corporations  are  highly  confiden¬ 
tial,  and  are  imparted  to  the  investing  public  only  in  so  far  as  the 
management  deems  it  good  policy  to  do  so.  Many  large  and  appar¬ 
ently  prosperous  concerns  publish  no  information  concerning  their 
finances,  and  this  in  no  way  reflects  upon  their  standing.  Concerns 
which  desire  to  secure  funds  from  a  wide  range  of  investors,  however, 
through  the  sale  either  of  stock  or  of  bonds,  are  practically  compelled 
to  give  out  a  certain  amount  of  information,  and  some  firms  consider 
it  good  policy  to  publish  financial  statements  even  though  they  are 
under  no  immediate  pressure  to  do  so.  Of  these  reports,  by  far  the 
most  important,  so  far  as  investment  analysis  is  concerned,  are  the 
balance  sheet  and  the  income  statement.  These  are  worthy  of  careful 
study  by  the  prospective  investor,  first,  because  the  elements  of 
strength  or  weakness  do  not  all  lie  on  the  surface  of  a  perfectly 
unbiased  report,  and,  second,  because  reports  are  often  colored  to  suit 
the  purposes  of  the  management,  and  evidence  of  this  coloring  may 
sometimes  be  detected,  particularly  if  a  series  of  statements  for  succes¬ 
sive  years  is  available  for  purposes  of  comparison.1 

The  following  questions  suggest  some  of  the  factors  which  the 
careful  investor,  or  the  speculator  operating  for  the  long  swing,  will 
take  into  consideration  in  analyzing  the  reports  of  industrial 
corporations: 

1  It  must  not  bo  overlooked  that  the  bias  is  not  always  in  the  direction  of 
making  the  corporation  appear  more  prosperous  than  it  really  is.  For  purposes 
connected  with  market  manipulation,  or  for  the  sake  of  the  effect  upon  competi¬ 
tion,  in  recent  years  also  on  account  of  income  taxation,  it  is  frequently  desirable 
to  make  the  prosperity  appear  less  than  it  actually  is. 


THE  ANALYSIS  OF  SECURITIES 


195 


A.  QUESTIONS  ON  THE  BALANCE  SHEET 

1.  At  what  time  was  the  balance  sheet  drawn?  For  instance,  does 
it  reflect  a  peculiar  seasonal  situation  ?  Does  it  reflect  the  actual 
position  or  that  which  will  obtain  after  a  proposed  issue  of  new  securi¬ 
ties?  The  practice  of  issuing  balance  sheets  “adjusted  to  show  the 
effect  of  the  present  financing,”  which  was  popular  in  connection  with 
the  distress  flotations  of  1920-21,  operates  frequently  to  cover  up  a  very 
weak  current  position.  By  subtracting  the  amount  of  the  new  issue 
from  the  fixed  liabilities  and  adding  a  similar  amount  to  the  current 
liabilities,  or  subtracting  it  from  the  cash,  an  approximation  of  the 
current  position  can  be  obtained.1 

2.  How  are  the  fixed  assets  valued?  This  information  is  not 
always  obtainable,  but  can  generally  be  secured  in  connection  with 
new  issues.  In  analyzing  statements  of  corporations  which  are  not 
in  the  market  to  sell  securities,  some  idea  of  the  valuation  method  can 
sometimes  be  gotten  by  comparing  the  valuation  of  fixed  assets  with 
that  of  other  corporations  engaged  in  a  similar  line  of  business,  or 
checking  through  a  series  of  statements  to  see  whether  the  growth  has 
corresponded  to  the  growth  of  other  items.  Sudden  increases  in 
value  assigned  to  fixed  assets  frequently  indicate  a  desire  to  cover  up 
the  depletion  of  surplus  through  business  losses. 

3.  Are  depreciation  reserves  adequate ,  and  are  the  depreciation  allow¬ 
ances  consistent  ?  Manipulation  of  the  depreciation  reserve  is  a 
favorite  method  of  producing  misleading  results  in  the  calculation  of 
net  income.  In  many  cases,  however,  it  is  impossible  to  tell  accurately 
whether  this  has  been  done,  because  the  only  figures  given  are  for 
depreciated  value  of  assets. 

4.  Are  the  figures  for  good-will  reasonable?  This  item  is  of  less 
importance  than  it  is  frequently  judged  to  be.  There  is  a  strong 
prejudice  in  favor  of  a  “clean”  balance  sheet  with  no  intangible 
assets,  but  if  the  good-will  item  is  shown  separately  so  that  it  is  possible 
to  see  what  the  tangible  assets  amount  to,  the  inclusion  of  a  large 
item  of  good-will  offset  by  a  correspondingly  large  item  of  sur- 

1  For  example,  a  prospectus  of  a  bond  issue,  gotten  out  by  a  reputable  bond 
house  early  in  1920,  emphasized  by  the  use  of  black-faced  type  the  current  ratio 
of  18:1,  obtained  by  applying  part  of  the  prospective  net  return  from  the  bond 
issue  against  current  liabilities  and  adding  the  remainder  to  the  cash.  The  actual 
ratio  was  apparently  about  1:1.  In  this  case,  it  happened  that  the  sale  of  the 
bond  issue  was  never  completed. 


196 


RISK  AND  RISK-REARING 


plus,  is  an  item  neither  of  strength  nor  of  weakness.  If  there  is 
a  large  good-will  item  and  the  surplus  is  not  sufficient  to  offset  it, 
the  stock  is  shown  to  represent  wholly  or  partially  a  capitalization 
of  actual  or  anticipated  earning  power  and  not  an  actual  investment. 
In  the  case  of  a  going  concern,  even  this  does  not  of  itself  indicate  a 
weak  position.  The  earnings  are  the  significant  item.  In  the  case 
of  a  new  company  with  no  record  of  earnings,  a  large  item  of  good-will, 
offset  by  stock  issues,  indicates  that  the  stock  has  no  present  value, 
and  the  risks  of  the  enterprise  will  fall  on  the  prior  lien  securities, 
which  will  nevertheless  have  only  a  limited  claim  to  the  earnings. 

5.  Are  the  figures  in  the  investment  account  satisfactory?  The 
investment  item  is  frequently  difficult  of  interpretation.  If  small,  it 
may  be  disregarded,  but  in  the  case  of  a  holding  company  it  is  impor¬ 
tant  to  know  on  what  basis  the  securities  of  subsidiaries  are  valued. 
Sometimes  advances  to  subsidiaries  which  are  uncollectible  are  carried 
as  investments,  and  sometimes  the  item  represents  fictitious  book 
values  of  subsidiaries,  securities  which  have  no  market,  and  whose 
value  to  the  parent  company  bears  little  relation  to  the  figure  at  which 
they  are  carried  into  the  balance  sheet.  Information  concerning  this 
item  is  not  readily  obtainable;  in  case  it  is  not  to  be  had,  large  figures 
for  investment  should  be  given  little  weight  in  evaluating  the  strength 
of  the  company. 

6.  What  is  the  ratio  of  quick  assets  to  current  liabilities?  This 
item  is  more  important  in  analyses  made  for  use  in  passing  on  applica¬ 
tions  for  short-time  credit  than  it  is  in  investment  analysis.  Two  to 
one  has  been  widely  accepted  as  a  normal  minimum  ratio,  though  the 
significance  of  a  variation  from  this  ratio  is  quite  different  at  different 
times  of  the  year  and  at  different  stages  of  the  cycle.  Wide  variations 
from  this  ratio  are  not  necessarily  indicative  of  abnormally  weak  or 
strong  positions,  but  there  should  be  some  satisfactory  explanation 
for  them. 

7.  Is  the  inventory  account  satisfactory?  Excessive  inventories  are 
a  source  of  weakness  in  times  of  falling  prices  and  of  strength  in  times 
of  rising  prices.  It  is  this  fact  that  makes  the  current  ratio  (ratio  of 
quick  assets  to  current  liabilities)  of  such  different  significance  at 
different  stages  of  the  cycle.  The  item  has  very  different  meaning, 
moreover,  in  the  case  of  corporations  which  hold  inventories  for  sale 
from  its  significance  where  the  inventories  are  used  up  in  furnishing 
services  whose  value  does  not  fluctuate  with  changing  values  of  the 
inventory.1 

1  See  p.  193. 


THE  ANALYSIS  OF  SECURITIES 


197 


8.  Is  the  net  working  capital  adequate?  Corporations  which  show 
a  narrow  margin  of  working  capital  above  absolute  requirements  in 
times  of  prosperity  are  apt  to  be  the  first  to  collapse  in  times  of 
adversity. 

9.  Does  new  financing  appear  to  he  imminent  ?  This  question  is 
closely  related  to  the  preceding  one.  It  is  usually  poor  policy  to  buy 
the  stock  of  a  corporation  just  prior  to  the  annoui  cement  of  new 
financing,  particularly  in  times  of  liquidation  and  depression,  unless 
the  credit  of  the  corporation  is  very  good  indeed. 

10.  What  is  the  character  of  the  surplus  ?  Does  it  seem  to  represent 
profits  available  for  distribution,  profits  permanently  reinvested, 
premium  from  stock  sales,  or  capitalization  of  hopes  through  inflation 
of  the  good-will  or  fixed  asset  items  ?  Some  corporations  habitually 
transfer  surplus  permanently  reinvested  to  the  capital  account  through 
stock  dividends;  others  allow  it  to  remain  in  the  surplus  account. 
From  the  standpoint  of  the  preferred  stockholders  and  the  bond¬ 
holders,  the  former  policy  is  preferable  as  it  makes  it  impossible  to 
distribute  the  accumulated  surplus  to  stock-holders  through  cash 
dividends. 


B.  QUESTIONS  ON  THE  INCOME  STATEMENT 

i.  Is  the  income  ample  to  cover  the  requirements?  These  include 
interest,  dividends,  sinking  funds,  amortization  of  discount,  etc.,  on 
the  security  under  consideration,  together  with  all  prior  claims.  In 
most  lines  of  business,  the  income  in  a  normal  year  should  cover  inter¬ 
est  requirements  on  a  given  bond  three  or  four  times  to  entitle  it  to  a 
conservative  rating.  Preferred  stocks  require  a  higher  margin  of 
safety  to  entitle  them  to  an  equally  good  rating,  as  they  are  likely  to 
have  their  lien  impaired  by  the  issuance  of  bonds  with  a  prior  lien. 
Even  when  this  is  apparently  rendered  impossible  by  stipulation  in 
the  indenture  covering  the  preferred  stock,  there  is  always  the  prob¬ 
ability  that  bank  loans  and  trade  indebtedness  will  accumulate,  and 
these  claims  always  come  ahead  of  the  claims  of  the  stock.  When 
this  has  taken  place,  if  the  corporation  has  difficulty  in  meeting 
maturing  claims,  the  preferred  stockholders  are  likely  to  be  asked  to 
sanction  a  bond  issue  to  refund  the  indebtedness,  and  they  can  gain 
no  advantage  by  refusing.  Moreover,  in  case  of  reorganization,  it  is 
customary  to  treat  preferred  stock  in  much  the  same  way  as  common, 
no  matter  how  amply  its  priority  has  been  protected  by  stipulations 
which  appear  to  make  it  almost  the  equivalent  of  a  bond. 


198 


RISK  AND  RISK-BEARING 


Common  stocks  should  earn  twice  the  dividend,  if  the  dividend 
is  capitalized  in  the  selling  price  at  anything  like  the  going  rate  for  safe 
investments.  There  is  much  more  variability  in  the  ratings  of  com¬ 
mon  stocks,  however,  for  the  price  discounts  all  probable  future 
increases  of  earnings,  and  this  factor  may  justify  a  price  far  in  excess 
of  what  the  present  earnings  or  dividends  would  support. 

2.  Have  inventory  losses  been  carried  into  the  income  statement? 
During  the  recent  period  of  falling  prices,  many  corporations  charged 
their  inventory  and  other  extraordinary  losses  direct  to  surplus  or 
to  reserves  set  up  previously,  while  others  charged  them  to  current 
income.  Either  method  is  defensible,  but  in  comparing  the  showing 
made  by  different  corporations  it  is  important  that  a  difference  of 
policy  in  this  regard  be  not  overlooked. 

3.  Have  earnings  been  manipulated  by  abnormal  charges  to  reserves? 
Reserves  are  of  two  classes:  first,  the  reserves  for  depreciation,  bad 
debts,  and  similar  items,  which  represent  an  actual  correction  of  the 
book  value  of  asset  items,  and,  second,  proprietary  reserves,  such  as 
“Reserve  for  Contingencies,”  “Reserve  for  Inventory  Shrinkage/’ 
“Dividend  Reserve,”  which  are  merely  ear-marked  surpluses.  By 
making  charges  to  the  first  class  of  reserves  unduly  small,  the  earnings 
may  be  padded  to  conceal  the  effects  of  bad  management  or  mis¬ 
fortune;  by  making  them  excessive,  or  by  making  charges  to  the 
second  class  of  reserves  against  earnings,  instead  of  against  surplus, 
the  earnings  can  be  made  to  appear  smaller  than  they  really  are. 
Examination  of  the  reserve  accounts  will  often  make  such  manipula¬ 
tion  evident. 


C.  QUESTIONS  ON  THE  FINANCIAL  HISTORY 

1.  Has  the  growth  of  gross  and  net  earnings  kept  pace  with  the  growth 
of  the  industry  ? 

2.  Has  the  working  capital  been  increasing  with  the  growth  of  the 
business?  An  increase  of  surplus  or  of  capital  accompanied  by  a 
decrease  of  working  capital  means  that  earnings  have  been  made  in 
the  form  of  increased  quantity  or  higher  valuation  of  fixed  assets. 
Such  absorption  of  earnings  in  plant  is  not  necessarily  unfavorable, 
especially  in  a  rapidly  growing  business,  but  it  may  mean  that  a 
showing  of  profits  is  being  made  through  charges  to  betterment  of 
what  are  really  repairs,  or  through  excessive  valuation  of  fixed  assets. 
It  is  much  easier  to  verify  the  bona  fide  character  of  earnings  accumu¬ 
lated  in  quick  assets  than  of  those  which  appear  in  plant  gains.  More- 


THE  ANALYSIS  OF  SECURITIES 


199 


over,  even  if  the  gains  so  shown  are  actual,  there  is  indication  of  danger 
that  the  business  is  expanding  too  rapidly  for  safety. 

3.  Has  the  dividend  policy  been  liberal  or  conservative?  From  the 
standpoint  of  bondholders  and  preferred  stockholders,  a  policy  of 
dispensing  dividends  freely  to  common  stockholders  is  objectionable; 
from  the  standpoint  of  the  buyer  of  common  stock,  the  answer  is  not 
so  simple.  Excessive  liberality  indicates  a  weakness,  but  the  question 
what  constitutes  excessive  liberality  depends  on  such  circumstances 
as  the  variability  of  the  earnings,  the  necessity  of  maintaining  large 
reserves  against  inventory  and  credit  losses,  the  amount  of  borrowed 
capital  used,  concerning  which  no  brief  general  statement  is  likely  to 
be  of  value. 

D.  QUESTIONS  ON  CORPORATE  POLICY  AND  PERSONNEL 

1.  What  is  the  character  of  the  banking  connections  ?  Naturally,  the 
fact  that  a  corporation’s  securities  are  underwritten  by  the  leaders  in 
the  business  of  handling  securities  of  the  type  in  question  is  a  favorable 
point.  The  absence  of  such  connections,  however,  does  not  condemn 
a  security;  it  merely  makes  it  necessary  to  seek  a  reason  for  their 
absence.  Some  excellent  issues  are  brought  out  without  the  aid  of 
underwriters,  because  they  are  too  small  to  be  attractive  to  high-grade 
houses;  others,  because  the  concerns  issuing  them  feel  strong  enough 
to  dispense  with  the  investment  bankers’  support. 

2.  Does  the  management  seek  publicity  for  its  financial  successes? 
As  a  rule,  it  is  an  unfavorable  sign  if  the  management  seems  anxious 
to  secure  publicity  for  its  large  profits.  Very  profitable  enterprises 
are  more  likely  to  wish  to  avoid  undue  publicity  because  of  its  effect 
in  stirring  up  competition  and  also  because  it  increases  public 
pressure  for  lower  prices  for  their  products.  However,  there  are  very 
successful  firms  which  pursue  a  policy  opposite  to  that  of  the  majority, 
making  use  of  their  financial  success  as  a  means  of  attracting  attention 
to  the  merits  of  their  products.  When  the  management  is  unusually 
willing  to  have  its  profits  advertised,  it  creates  the  suspicion  that  a 
market  is  being  maintained  on  which  insiders  may  sell  out  their 
holdings  but  such  suspicion  is  not  always  justified. 

3.  Have  dividends  been  increased  recently  more  than  earnings  seem 
to  justify  ?  Or  have  extra  cash  dividends  and  stock  dividends  been 
granted?  The  bearing  of  this  question,  from  the  standpoint  of  the 
bondholder  and  the  preferred  stockholder,  has  been  indicated  in  con¬ 
nection  with  other  questions.  The  receipt  of  dividends  is  of  course 


200 


RISK  AND  RISK-BEARING 


ihe  only  thing  that  gives  value  to  stocks,  so  that  increases,  if  there  is  a 
probability  of  their  being  permanent,  are  favorable.  Very  large 
distributions,  however,  are  likely  to  be  interpreted  as  being  more  favor¬ 
able  than  they  really  are.  During  a  period  of  rapid  expansion,  when 
large  profits  are  being  earned  and  the  volume  of  business  is  increasing, 
corporation  managers  are  reluctant  to  disburse  unusually  large 
amounts  to  stockholders  for  the  reason  that  the  funds  are  at  that  time 
especially  valuable  to  the  business.  It  is  at  the  end  of  a  period  of 
high  prosperity  that  accumulated  earnings  can  best  be  distributed,  and 
extra  dividends  are  therefore  an  index  of  past,  rather  than  of  prospec¬ 
tive,  prosperity. 

Moreover,  there  are  indications  that  stock  dividends,  extra  divi¬ 
dends,  and  increases  of  cash  dividends  have  sometimes  been  used  as  a 
cover  for  the  distribution  of  stock  by  insiders  to  the  general  public. 
The  experience  of  1907,  1911,  1917,  and  the  early  part  of  1920,  upon 
all  of  which  occasions  unusual  increases  in  dividends  were  accompanied 
for  many  months  by  declining  stock  prices,  indicates  that  the  good 
news  of  dividend  increases  was  regarded  by  large  holders  as  an  oppor¬ 
tunity  to  dispose  of  their  stocks. 

Railway  and  public  utility  securities  present  an  entirely  different 
problem. — In  the  first  place,  the  capitalization  of  railways  and  utilities 
is  usually  more  complex  than  is  the  financial  structure  of  industrial 
companies.  One  principal  reason  for  this  is  that  there  is  less  variation 
in  the  net  earnings  of  railways  and  utilities.  It  is  therefore  possible 
to  issue  underlying  bonds  which  offer  a  very  high  degree  of  safety, 
since  there  is  slight  possibility  of  such  great  decline  of  earnings  as 
will  imperil  them,  while  at  the  same  time  part  of  the  necessary  capital 
must  be  secured  through  the  offer  of  speculative  inducements  because 
there  is  no  assurance  of  sufficient  income  to  pay  a  return  on  the  entire 
capital.  Moreover,  in  the  case  of  the  railroads,  there  are  usually  his¬ 
torical  reasons  for  the  existence  of  numerous  bonds  secured  by  liens 
on  specific  parts  of  the  property,  and  also  for  numerous  strata  of 
bonds  superimposed  upon  the  same  property.  Without  attempting 
to  work  out  a  detailed  method  of  analysis  of  railway  and  utility  securi¬ 
ties,  the  following  points  of  difference  from  the  industrials  may  be 
noted: 

1.  The  property  account  is  of  even  less  importance  in  railway  and 
utility  statements  than  it  is  in  industrial  statements. — The  bulk  of  the 
property  is  not  salable  for  any  other  purpose  than  that  for  which  it  is 
being  used,  and  the  separate  parts  of  the  property  have  much  less 


THE  ANALYSIS  OF  SECURITIES 


201 


value  as  separate  units  than  they  do  as  a  single  property.  The 
security  of  the  investor  depends  almost  entirely  on  the  continued 
earning  power  of  the  corporation. 

2.  The  current  assets  and  current  liabilities  are  of  much  less  impor¬ 
tance  than  in  industrial  statements. — The  inventories  are  not  held  for 
sale;  the  accounts  receivable  are  small;  and  it  is  rarely  the  case  that 
sufficient  capital  is  obtained  through  bank  loans  to  make  the  problem 
of  meeting  maturities  of  short-time  obligations  a  serious  one. 

3.  Conversely ,  the  proportion  of  fixed  charges  to  net  income  is  much 
more  important  than  it  is  in  most  industrial  corporations. — The  cost  of 
capital  is  always  an  important  item,  and  if  too  large  a  proportion  is 
obtained  through  securities  bearing  a  fixed  charge,  some  sort  of  re¬ 
organization  to  scale  down  those  charges  becomes  necessary.  Fixed 
charges  usually  play  a  less  important  part  in  industrial  failure  and 
reorganization. 

4.  Relations  with  public  authorities  are  of  greater  importance  in 
the  case  of  railways  and  public  utilities  than  in  the  case  of  industrials. — 
Typically,  the  rates  charged  by  utilities  are  fixed. by  some  public 
authority  or  are  subject  to  review,  and  the  demand  which  they  serve 
is  so  inelastic  that  their  income  is,  to  a  large  extent,  determined  by 
the  rates  they  are  allowed  to  charge.  Hence  changes  in  the  attitude 
of  legislatures,  courts,  and  of  the  public  are  of  primary  importance. 

5.  Railway  reports  are  more  uniform  and  easier  of  interpretation 
than  industrial  reports;  public  utility  reports  less  so. — The  uniform 
system  of  accounting  prescribed  by  the  Interstate  Commerce  Com¬ 
mission  makes  it  possible  to  secure  prompt  and  intelligible  information 
concerning  the  finances  of  the  railways.  The  only  serious  discrepancy 
between  one  such  report  and  another  arises  from  the  item  of  mainte¬ 
nance.  Formerly,  there  was  wide  difference  of  policy  between  different 
roads  as  to  what  should  be  considered  as  expense  and  what  charged 
as  betterment.  Uniformity  in  this  regard  has  been  secured  in  recent 
years,  but  there  is  still  a  considerable  margin  of  uncertainty  in  the 
figures  for  maintenance  and  consequently  in  the  net  earnings,  on 
account  of  the  extent  to  which  maintenance  can  be  deferred  or 
hastened. 

Public-utility  reports  are  less  uniform,  and  are  frequently  very 
difficult  of  interpretation  because  of  the  lack  of  adequate  information 
concerning  the  amounts  allowed  for  depreciation,  particularly  in  the 
accounts  of  subsidiary  companies  of  large  holding  companies.  The 
same  ambiguity  occurs  in  the  reports  of  industrial  corporations,  but 


202 


RISK  AND  RISK-BEARING 


it  is  of  more  importance  in  the  case  of  the  utilities  on  account  of  the 
very  large  amount  of  fixed  capital  employed. 

Finally,  it  remains  to  consider  the  factor  which  is  most  important 
of  all,  but  most  difficult  of  access  for  the  small  investor — the  character 
of  the  management.  Upon  the  ability  and  character  of  the  men  to 
whom  the  management  of  his  capital  is  intrusted,  the  investor  must 
rely  for  honest  and  capable  service.  This  factor,  however,  cannot  be 
learned  from  the  perusal  of  annual  reports.  Some  information  con¬ 
cerning  the  personality  and  past  performance  of  prominent  industrial 
leaders  may  be  gleaned  from  the  financial  press,  but  the  reader  is 
usually  uncertain  as  to  the  extent  to  which  the  information  so  obtained 
is  inspired  by  the  leader  himself,  or  by  those  who  have  a  personal  inter¬ 
est  in  promoting  his  reputation.  Something  can  be  learned  by 
inquiry  through  bankers,  bond  salesmen,  and  brokers,  but  much  time 
and  experience  is  necessary  to  sift  the  wheat  from  the  chaff  in  current 
gossip  concerning  men  prominent  in  the  world  of  finance. 

The  best  index  to  the  character  and  capacity  of  an  industrial 
leader  is  the  record  of  the  corporations  he  has  led.  The  man  who  has 
been  for  years  connected  with  the  management  of  corporations  whose 
record  of  growth,  progressive  policy,  fair  treatment  of  investors,  and 
financial  stability  is  good,  comes  to  command  the  confidence  of  the 
business  community,  and  his  name  lends  prestige  to  weaker  or  newer 
businesses  with  which  he  may  later  associate  himself.  Inferences 
drawn  from  the  reputation  of  men  who  are  associated  with  the  manage¬ 
ment  of  otherwise  doubtful  enterprises  are  by  no  means  infallible,  but 
in  most  cases  no  better  guide  is  available.1 

Diversification  is  a  very  effective  method  of  reducing  risk ,  so  effective, 
indeed,  that  it  may  well  be  said  to  be  the  foundation  principle  of 
investment.  No  analysis  of  financial  statements  and  market  history 
is  adequate  to  insure  safety,  unless  the  investor  is  content  with  the 
return  obtainable  from  the  highest  grade  of  government  bonds.  As 
soon  as  an  effort  is  made  to  secure  a  larger  return  on  one’s  capital  than 
that  obtainable  through  savings  bank  deposits  and  purchases  of  liberty 
bonds  and  wrar  savings  stamps,  the  factor  of  risk  appears:  risk  that 
the  investor’s  analysis  may  fail  through  negligence  or  misunderstand¬ 
ing  on  his  part;  risk  that  financial  reports  may  be  deliberately  mis- 

1  In  relying  upon  this  sort  of  information,  however,  care  must  be  taken  to  avoid 
placing  confidence  in  the  reputation  of  men  who  are  only  nominally  associated  with 
the  management,  or  who,  though  once  active,  have  ceased  to  play  a  dominant 
r61e  in  the  corporation’s  affairs. 


THE  ANALYSIS  OF  SECURITIES 


203 


leading;  risk  that  quite  unpredictable  misfortune  may  overtake 
borrowers  whose  position  appears  to  be  the  strongest. 

Against  all  these  dangers,  diversification  offers  the  largest  measure 
of  protection.  The  wider  the  range  of  investments  the  less  is  the 
probability  that  all  or  the  larger  portion  will  turn  out  to  be  weaker  than 
they  appear  to  be.  This  is  simply  the  application  of  the  law  of  large 
numbers;  the  elimination  of  risks  through  combination.1 

To  obtain  the  maximum  benefit  of  distribution,  it  is  necessary  not 
merely  that  the  number  of  separate  securities  or  separate  borrowers 
represented  shall  be  large;  it  is  equally  important  that  they  shall 
represent  enterprises  exposed,  as  far  as  possible,  to  different  hazards. 
If  possible,  the  diversification  should  be  wide  enough  so  that  the 
failure  of  any  one  obligor,  or  of  any  group  exposed  to  similar  hazards, 
will  not  create  serious  embarrassment.  A  properly  diversified  list  will 
contain  representatives  of  all  the  leading  classes  of  investment  securi¬ 
ties;  and  within  each  group  will  contain  representatives  of  as  diverse 
geographical,  industrial,  and  commercial  conditions  as  is  reasonably 
possible.  The  inclusion  of  representatives  of  all  the  different  standard 
types  of  security  is  necessary  in  order  to  secure  protection  against 
the  effects  of  a  decline  of  the  investment  standing  of  some  one  entire 
group,  such  as  happened  in  the  case  of  the  public  utilities  and  also  in 
the  case  of  European  government  securities  during  the  Great  War. 
Geographical  diversification  insures  protection  against  the  effects  of 
crop  failure  and  reduces  the  effect  of  the  business  cycle.  Diversifica¬ 
tion  of  industries  represented  also  reduces  the  effect  of  cyclical  changes 
and  of  the  collapse  of  individual  industries.  Bonds  are  in  general 
more  conservative  investments  than  stocks,  but  a  sprinkling  of  indus¬ 
trial  stocks  serves  as  an  offset  to  the  losses  incurred  by  investors  in 
times  of  rapidly  rising  prices,  for  dividends  on  industrial  stocks  are 
likely  to  increase  at  such  times,  while  bond  interest  remains  stationary 
in  nominal  amount  and  declines  in  real  purchasing  power.2 

In  grouping  the  securities  of  railroads  or  industrial  corporations, 
an  additional  element  of  safety  can  be  secured  by  balancing  the 
securities  of  strong  competitors  against  one  another,  so  that  a  serious 
decline  in  the  income  of  one,  if  caused  by  competition,  is  likely  to  be 
offset  by  a  gain  on  the  part  of  the  other,. 

1  See  chap.  ii. 

2  The  experience  of  many  colleges  and  other  endowed  institutions  during 
recent  years  has  emphasized  the  desirability  of  balancing  the  customary  heavy 
investments  in  fixed  income  securities  with  a  proportion  of  securities  whose  income- 
producing  capacity  will  be  likely  to  increase  with  the  level  of  prices. 


204 


RISK  AND  RISK-BEARING 


If  investments  are  selected  in  such  a  way  as  to  secure  actual  inde¬ 
pendence  of  risks,  the  probability  of  total  loss  becomes  negligibly 
small  with  a  very  short  list,  but  proper  diversification  is  not  attained 
till  the  number  of  independent  risks  is  large  enough  so  that  any 
probable  accidental  combination  of  unfortunate  developments  in 
different  fields  will  not  create  serious  embarrassment.  For  example, 
if  a  fund  is  divided  between  four  securities,  and  the  probability  of 
default  on  any  one  of  them  is  figured  at  one  chance  in  twenty,  there  is 
only  one  chance  in  160,000  that  all  will  fail,  assuming  that  the  causes 
of  failure  are  fully  independent,  but  the  probability  that  one  or 
another  will  fail  is  about  three  in  sixteen.  If  the  investor  is  dependent 
upon  the  income  of  the  fund  to  meet  pressing  needs,  good  policy  would 
not  sanction  his  running  so  great  a  risk  of  losing  one-fourth  of  his 
principal.  Either  the  fund  must  be  distributed  more  widely  or  safer 
securities  must  be  chosen.  This  illustration  points  to  the  reason 
why  well-to-do  investors  often  purchase  higher-yielding  securities 
than  are  recommended  for  small  buyers.  The  larger  lists  permit  a 
wider  diversification,  so  that  the  failure  of  any  one  member  of  the 
group  does  not  eat  up  all  the  income  from  the  rest.  Of  course  the 
probability  that  there  will  be  some  losses  also  increases  with  the 
number  of  items  included  in  one’s  purchases,  but  the  longer  the  list 
the  closer  the  actual  loss  is  likely  to  run  to  the  amount  which  is  antici¬ 
pated  and  discounted  in  the  purchase  price.  As  was  noted  in  chapter 
vi,  investors  who  do  not  command  a  sufficient  amount  of  capital  to 
secure  diversification  in  their  own  investments  can  obtain  it  indirectly 
through  the  mediation  of  savings  banks  and  other  financial  institu¬ 
tions.  The  recent  development  of  the  “baby  bond”  and  of  stocks  of 
low  par  value  has  made  it  possible  for  the  small  investor  to  choose 
from  an  attractive  list  of  offerings  and  obtain  much  more  satisfactory 
diversification  than  was  the  case  a  few  years  ago.  The  trouble  and 
cost  of  investigating  the  soundness  of  securities  is  as  great  for  the  buyer 
of  $100  worth  as  for  the  buyer  of  $5,000  worth,  however,  so  that  the 
large  investor  can  afford  to  spread  his  investments  somewhat  more 
widely  than  can  the  small  buyer0 


CHAPTER  XI 


SPECULATION  IN  COMMODITIES 

In  a  survey  of  the  methods  used  in  speculation  in  commodities, 
our  attention  is  directed  at  the  outset  to  a  distinction  similar  to  the 
one  we  observed  in  our  study  of  the  security  markets,  between  the 
listed  and  the  unlisted  securities.  This  is  the  distinction  between 
commodities  which  are  traded  in  through  organized  exchanges  and 
those  which  have  no  such  market.  In  both  cases  the  organized 
market  is  not  essential  to  speculation  and  there  is,  in  fact,  a  con¬ 
siderable  speculative  interest  outside  the  field  which  they  cover,  but 
the  speculator’s  tasks  of  executing  trades,  obtaining  information,  and 
financing  his  operations  are  greatly  simplified  by  the  exchange  organi¬ 
zation.  Because  of  the  concentration  of  speculative  interest  in  them, 
our  attention  will  be  directed  primarily  to  the  characteristic  features 
of  the  organized  commodity  markets  and  the  methods  used  in  operat¬ 
ing  through  them. 

In  its  external  features  and  in  many  of  its  methods  of  operation, 
the  typical  commodity  exchange  is  very  similar  to  the  stock-exchange 
organization  which  was  described  in  a  preceding  chapter.  A  com¬ 
modity  exchange  is  an  organization  of  brokers,  dealers,  and  specu¬ 
lators,  formed  for  the  purpose  of  facilitating  the  business  of  buying  cer¬ 
tain  staple  commodities  and,  incidentally,  to  promote  the  common 
interests  of  its  members  through  publicity,  legislative,  informational, 
and  such  other  services  as  it  may  be  practicable  for  it  to  render. 
The  organization  of  the  exchanges,  the  method  of  executing  trades, 
the  ticker  system,  and  most  of  the  rules  and  practices  are  very  similar 
to  those  which  have  been  described  in  connection  with  stock-exchange 
trading. 

The  most  distinctive  feature  of  the  trade,  through  the  speculative 
produce  exchanges  in  the  United  States,  is  the  futures  contract .  The 
peculiarities  of  this  contract  explain  most  of  the  differences  between 
grain  or  cotton  speculation  and  stock  speculation.  A  futures  contract 
may  be  defined  as  a  contract  for  the  sale  of  a  stipulated  amount  of  a 
specified  grade  of  some  commodity  at  a  fixed  price  at  a  future  date. 
Typically,  it  contains  the  following  special  features:  First,  the  specific 
provisions  of  the  contract  are  determined  by  the  rules  of  the  exchange 


205 


200 


RISK  AND  RISK-BEARING 


the  actual  bargain  being  made  in  a  highly  informal  way.  The  rules 
and  practices  of  the  exchange  are  implied  in  each  bargain,  in  the 
absence  of  a  specification  to  the  contrary.  Second,  the  futures  con¬ 
tract  is  a  basis  contract,  which  means  that  the  commodity  delivered 
under  it  may  be  either  of  the  “contract  grade”  or  of  some  other  grade 
which  may  be  delivered  at  the  seller’s  option  at  a  price  above  or  below 
the  contract  price.  The  method  of  determining  the  differential 
varies  in  different  exchanges.  Third,  the  seller  is  given  the  option 
of  making  delivery  at  any  date  between  specified  limits;  in  this 
country  at  any  date  within  a  specified  calendar  month.  Fourth,  the 
enforcement  of  the  contract  is  insured  by  a  provision  that  a  specified 
amount  known  as  a  margin  shall  be  deposited  with  some  third  party 
by  each  of  the  contracting  parties.  These  deposits  are  intended 
to  protect  the  seller  against  a  refusal  of  the  buyer  to  make  good  his 
contract  in  case  of  a  fall  in  prices,  and,  conversely,  to  protect  the 
buyer  against  a  default  on  the  seller’s  part  in  case  of  a  rise.  Fifth, 
delivery  is  effected  by  delivery  of  warehouse  receipts  for  the  com¬ 
modity,  which  must  be  stored  in  a  specific  place — usually  in  approved 
warehouses  in  the  city  in  which  the  exchange  is  situated. 

While  a  futures  market  is  not  essential  to  commodity  speculation 
and  has  other  uses  besides  promoting  speculation,  such  a  market  is 
extremely  convenient  for  the  speculator’s  purposes.  Its  great 
advantage  is  that  until  delivery  date  arrives,  the  buyer  does  not  have 
to  pay  for  the  goods  which  he  has  bought,  nor  does  the  seller  have  to 
own  them.  This  tremendously  simplifies  the  financing  of  commodity 
speculation.  The  speculator  who  in  October  buys  wheat  for  May 
delivery  need  not  worry  about  paying  for  it  until  May  comes,  and  if 
he  sells  before  that  time  can  have  the  grain  delivered  direct  to  his 
buyer  by  the  person  from  whom  he  bought,  so  that  he  does  not  have 
to  advance  any  capital  except  for  margin  purposes.  On  the  other 
hand,  the  speculator  who  believes  that  wheat  is  likely  to  fall  in  price 
can  sell  in  the  fall  for  May  delivery  and  need  not  purchase  the  wheat 
to  fulfil  his  contract  until  the  last  day  of  May.  Whenever  he  buys 
he  can  have  settlement  made  direct  between  his  buyer  and  his  seller, 
without  any  responsibility  except  to  keep  his  margins  good  and 
settle  his  losses.1 

1  Commodity  speculation  can  also  be  carried  on  through  the  use  of  warehouse 
receipts  for  commodities  in  storage,  in  much  the  same  way  that  stock  speculation 
is  carried  on  through  the  transfer  of  certificates,  the  warehouse  receipts  being 
loaned  for  short  sales  and  the  buyers  paying  cash  for  them.  This  method  was 
used  before  the  general  development  of  the  futures  market.  Under  this  system 


SPECULATION  IN  COMMODITIES 


207 


The  following  are  the  futures  markets  in  the  United  States,  as 
listed  by  the  Federal  Trade  Commission: 


Trading  in  Cereal  Futures — Grains  Traded  in  on  Each  Exchange 

in  the  United  States 


Chicago . 

Wheat 

Corn 

Oats 

Rye 

Barley 

Minneapolis . 

Wheat 

Oats 

Rye 

Barley 

Duluth . 

Wheat 

Rye 

Milwaukee . 

Wheat 

Corn 

Oats 

Omaha . 

Wheat 

Corn 

Oats 

Kansas  City . 

Wheat 

Corn 

Oats 

St.  Louis . 

Wheat 

Corn 

Oats 

4 

Toledo . 

Wheat 

Corn 

Oats 

Baltimore . 

Corn 

San  Francisco . 

Oats 

Chicago  Open  Board. . 

Wheat 

Corn 

Oats 

There  is  also  at  Duluth  a  futures  market  for  the  special  variety  of  wheat 
known  as  durum.  There  is  similarly  a  market  for  kaffir  corn  (including 
milo  maize  and  feterita)  at  Kansas  City.  In  addition  to  the  food  grains, 
flax  futures  are  traded  in  at  Duluth.  Toledo  has  futures  markets  for  the 
several  important  kinds  of  hayseed — clover,  alsike,  and  timothy.  The 
New  York  Produce  Exchange  has  a  futures  market  in  cottonseed  oil.  At 
New  York,  also,  and  at  New  Orleans  are  important  markets  in  cotton 
futures.  Butter  and  eggs,  prior  to  the  entrance  of  the  United  States  into 
the  World  War,  were  traded  in  through  a  call  for  futures  on  the  New  York 
Mercantile  Exchange,  the  New  York  Butter  and  Eggs  Exchange,  and  the 
Chicago  Butter  and  Egg  Board.  Provision  futures  (pork  products)  are 
traded  in  at  Chicago'.* 1 

To  this  list  may  be  added  the  futures  market  in  coffee  and  sugar 
maintained  by  the  New  York  Coffee  Exchange,  and  the  recently 
established  market  for  cottonseed  oil  on  the  Chicago  Board  of  Trade. 
Leading  futures  markets  of  other  countries  include  a  very  active 
cotton  market  in  Liverpool,  silk  and  rice  markets  in  Tokyo,  and  large 
wheat  markets  in  Winnipeg,  Rosario,  Buenos  Aires,  and  Liverpool. 
A  great  many  other  commodities  have  at  one  time  or  another  had 
futures  markets  of  more  or  less  importance. 

The  qualifications  of  a  commodity  which  adapt  it  to  future 
trading  are:  first  and  most  important,  that  it  shall  be  susceptible  of 

the  speculative  buyer  has  to  meet  the  cost  of  storage,  insurance,  interest,  and  other 
carrying  costs,  and  commissions  are  higher  than  in  the  futures  market,  hence  the 
method  has  gone  out  of  use  except  for  commodities  not  traded  in  through  the 
exchanges. 

1  Report  of  the  Federal  Trade  Commission  on  the  Grain  Trade,  V,  31. 


208 


RISK  AND  RISK-BEARING 


accurate  classification  into  a  fairly  small  number  of  grades,  so  that 
buyers  may  have  a  definite  idea  of  what  they  are  likely  to  have 
delivered  to  them;  second,  that  there  shall  be  a  large  enough  interest 
in  the  commodity  so  that  would-be  buyers  can  be  fairly  sure  of  finding 
sellers  at  any  time,  without  bidding  up  the  price  out  of  reason,  and 
vice  versa,  that  sellers  shall  be  able  to  find  buyers  at  reasonable 
concessions  in  price;  and  third,  that  the  supply  of  the  commodity 
physically  available  shall  under  all  ordinary  conditions  be  quite 
large.  This  last  qualification  is  necessary,  in  order  to  protect  sellers 
against  the  danger  of  finding  the  entire  available  supply  bought  up 
and  held  off  the  market  when  they  try  to  obtain  the  goods  to  fulfil 
their  contracts. 

To  illustrate  the  customs  and  methods  of  future  trading,  the 
wheat  market  on  the  Chicago  Board  of  Trade  will  be  described  in 
some  detail.  The  Chicago  Board  of  Trade  is  an  incorporated  body 
of  about  i, 600  members.  As  noted  above,  it  provides  facilities  for 
trading  in  five  grains,  in  cottonseed  oil,  and  in  pork  provisions.  The 
speculative  trade  in  rye,  barley,  and  cottonseed  oil,  however,  is  quite 
negligible  in  volume,  and  oats,  short  ribs,  and  pork  also  comprise 
only  a  small  part  of  the  trading.  Wheat  and  corn  make  up  the  bulk 
of  the  grain  trade,  and  lard  is  the  speculative  leader  in  the  provisions 
group. 

The  management  of  the  Board  of  Trade  is  sufficiently  similar  to 
that  of  the  New  York  Stock  Exchange,  described  above,  to  make  a 
detailed  description  unnecessary.  In  theory,  the  membership  is 
not  closed,  a  contrast  to  the  organization  of  the  New  York  Stock 
Exchange,  which  it  will  be  remembered,  is  limited  to  1,100  members. 
In  practice,  however,  no  new  memberships  are  created.  The  market 
price  of  a  seat  is  usually  in  the  neighborhood  of  $7,000  to  $8,000 
while  the  fee  for  entry  through  the  creation  of  a  new  membership  is 
$25,000.  Hence  the  “open”  character  of  the  membership  is  more  a 
theory  than  a  practice. 

The  standard  futures  contract  of  the  Chicago  Board  of  Trade 
provides  for  trading  in  units  of  5,000  bushels  of  grain,  although  1,000- 
bushel  lots  of  wheat  are  handled  through  a  special  arrangement. 
Contracts  are  made  orally  just  as  is  the  case  in  the  stock  market. 
The  small  number  of  commodities  compared  with  the  great  number  of 
stocks  handled  in  the  Stock  Exchange  makes  the  organization  of  trad¬ 
ing  somewhat  simpler.  In  place  of  the  posts  which  designate  the  spots 
for  trading  in  the  different  securities  in  the  stock  exchange,  we  find 


SPECULATION  IN  COMMODITIES 


209 


on  the  floor  of  the  Chicago  Board  of  Trade  three  pits:  one  for  wheat, 
one  for  corn  and  oats,  and  one  for  provisions.  Trades  are  made  by 
oral  bids  and  offers,  and  confirmations  are  exchanged  at  the  close  of 
the  day’s  business.  The  wheat  contract  calls  for  the  delivery  of 
Number  Two  red  winter  wheat  at  the  seller’s  option  on  any  date  in 
the  month  specified.  Various  other  grades  are  deliverable  at  the 
seller’s  option  at  premiums  or  discounts.  As  these  differentials  are 
fixed  in  the  rules  and  are  changed  quite  infrequently,  one  would 
expect  that  they  would  frequently  get  out  of  line  with  the  actual 
differences  in  the  market  values  of  the  various  grades.  No  serious 
dissatisfaction  appears  to  exist  with  the  working  of  this  rule,  how¬ 
ever.  May,  July,  September,  and  December  are  the  only  deliveries 
for  which  any  considerable  number  of  contracts  are  sold. 

Members  carry  accounts  either  as  principals  or  as  agents  for 
outside  traders.  After  a  trade  has  been  made,  the  seller  and  the 
buyer  are  both  required  to  post  10  per  cent  of  the  amount  of  the 
transaction  with  one  of  certain  designated  banks,  as  security  for  the 
fulfilment  of  the  contract.  In  case  the  price  of  wheat  changes  mate¬ 
rially  before  the  delivery  date,  the  deposit  must  be  adjusted.  If,  for 
instance,  the  market  price  of  a  certain  contract  advances  five  cents 
per  bushel,  all  members  -who  have  that  contract  bought  from  others 
may  withdraw  five  cents  of  their  posted  margins,  and  may  demand 
that  the  sellers  post  additional  margin  to  that  amount.  The  practice 
in  regard  to  calling  for  these  margins  depends  upon  the  confidence 
which  the  traders  have  in  one  another’s  responsibility.  ’  These 
margins  posted  by  the  members  with  banks  must  not  be  confused 
with  the  margins  which  the  broker  requires  from  his  customer,  when 
dealing  as  an  agent  for  an  outside  party.  The  broker  is  entitled  to 
call  a  margin  from  his  customer  regardless  of  whether  he  is  himself 
required  to  post  a  margin  or  not.  There  is  no  rule  regarding  the 
size  of  the  margin  which  may  be  required  from  customers.  The 
actual  practice  varies  with  the  activity  of  the  market,  the  amount 
of  confidence  the  broker  has  in  his  customer’s  financial  responsibility, 
the  value  of  the  account  to  the  broker,  and  the  readiness  with  which 
the  customer  can  be  reached  in  an  emergency  in  order  to  call  on  him 
for  additional  security. 

The  fulfilment  of  all  contracts  is  made  by  the  delivery  of  ware¬ 
house  receipts  for  grain  stored  in  “ regular”  warehouses,  that  is, 
warehouses  which  have  been  authorized  by  the  directors  of  the 
exchange  to  handle  grain  for  delivery  on  contracts.  In  practice,  a 


210 


RISK  AND  RISK-BEARING 


great  majority  of  the  trades  do  not  involve  an  actual  delivery  of  grain 
directly  between  the  parties,  although  any  buyer  or  seller  can  obtain 
delivery  if  he  desires.  This  is  true  not  because  the  contracts  are 
fictitious,  but  because  in  most  cases  the  grain  is  resold  before  it  is 
delivered  to  the  original  purchaser.  The  methods  employed  in 
handling  these  transactions  have  been  the  subject  of  a  considerable 
amount  of  uninformed  criticism,  and  an  understanding  of  them  is 
fundamental  to  an  understanding  of  the  whole  system  of  future 
trading;  hence,  they  will  be  described  in  more  detail  than  would 
otherwise  be  necessary. 

Suppose  that  A,  a  speculator,  sells  to  B,  in  June,  5,000  bushels 
of  “September  wheat”  at  $1.10  a  bushel.  The  next  day  B  sells  the 
same  amount  at  $1.1 1  to  C.  None  of  the  parties  to  the  transaction 
makes  any  further  trade  in  this  contract  before  September.  It  is 
clear  that  when  delivery  time  arrives  the  situation  will  be  the  same 
as  if  A  had  sold  direct  to  C,  except  that  A  is  entitled  to  only  $1.10 
per  bushel  when  he  makes  delivery,  while  C  is  under  contract  to 
pay  $1.1 1,  the  difference  constituting  B’s  profit.  If,  therefore,  A 
makes  delivery  to  C  and  the  prices  are  adjusted  so  that  each  pays  and 
receives  what  he  would  have  gotten  if  trading  had  been  settled  by 
separate  deliveries,  the  result  is  the  same  as  though  separate  deliveries 
and  payments  had  been  effected,  and  a  great  saving  in  labor  results 
both  for  the  traders  and  for  the  banks.  The  courts  have  uniformly 
held  therefore  that  devices  by  which  A  is  substituted  for  B  in  the 
contract  with  C  are  legal,  so  long  as  delivery  is  actually  contemplated 
at  the  time  the  contract  is  entered  into.  For  facilitating  the  adjust¬ 
ment  of  accounts  which  wholly  or  partially  offset  one  another,  a  clear¬ 
ing  house  is  operated  by  the  management  of  the  Board  of  Trade. 
This  clearing  house  has  nothing  to  do  with  the  offsetting  of  the 
accounts,  but  only  provides  facilities  for  settling  the  balances  of  pay¬ 
ment  due  from  one  member  to  another.  The  following  methods  are 
used  in  working  out  the  settlement:1 

1.  Direct  settlement. — This  kind  of  settlement  occurs  when  each 
of  two  houses  has  sold  the  same  contract  to  the  other.  Suppose  that 
member  A  has  sold  to  member  B  50,000  bushels  of  September  wheat 
during  the  course  of  a  day’s  trading,  while  B  has  sold  to  A  60,000 
bushels  of  the  same  option.  It  is  clear  that  when  September  arrives 
the  trades  can  be  settled  by  the  delivery  of  10,000  bushels  by  B  to  A; 

1  This  account  is  based  chiefly  on  the  Report  of  the  Federal  Trade  Commission 
on  the  Grain  Trade ,  Vol.  V,  chap.  v. 


SPECULATION  IN  COMMODITIES 


2  1 1 


hence  the  remaining  account  may  as  well  be  offset  at  once,  leaving 
on  the  books  only  the  obligation  to  deliver  and  accept  the  10,000 
bushels.  In  this  case  B  is  said  to  be  “short”  to  A  10,000  bushels; 
A  to  be  long  from  B  the  same  amount.  On  the  next  day,  A’s  sales 
to  B  may  be  the  larger,  so  that  the  balance  will  be  wiped  out. 

If  all  the  trades  were  made  at  the  same  price  no  further  adjustment 
would  be  necessary,  but  since  prices  are  constantly  changing  the 
trades  offset  do  not  involve  an  exact  offset  in  the  cash  payments  due; 
the  balances  due  on  account  of  offsets  are  therefore  settled  in  cash. 
In  making  these  settlements,  the  clearing  house  is  utilized  to  effect 
an  offset  of  payments  due  between  the  members.  The  methods  used 
are  the  same  in  principle  as  those  used  in  bank  clearing  houses  and  in 
the  stock  clearing  house  described  in  chapter  viii. 

2.  Ring  settlement. — A  ring  is  formed  when  three  or  more  members 
have  trades  which  mutually  offset.  If  A  has  sold  to  B,  B  to  C,  and 
C  to  A,  and  the  facts  are  known,  the  trades  can  be  canceled  and  the 
differences  paid  quite  as  readily  as  when  there  are  only  two  parties 
to  the  offset.  The  following  diagram  illustrates  the  operation  of  the 
ring  system:1 

Illustration  op  the  Ring  Settlement  at  Chicago 


(A  is  assumed  to  have  bought  from  F  at  $1.51;  F  from  E  at  $1.47; 
E  from  D  at  $1.49;  D  from  C  at  $1.52;  C  from  B  at  $1.45;  B  from  A  at 

$1.50-) 


3.  Transfer. — The  making  of  rings  is  entirely  voluntary,  and  not  all 
houses  co-operate  in  the  somewhat  laborious  task  of  comparing  books 
in  order  to  locate  the  rings.  Trades  which  will  not  “ring  out,”  either 

1  From  the  Report  of  the  Federal  Trade  Commission  on  the  Grain  Trade ,  V,  223. 


212 


RISK  AND  RISK-BEARING 


because  of  refusal  of  members  to  participate  or  because  the  chain 
ends  with  a  house  which  is  accumulating  or  distributing  a  large  “line,” 
may  be  disposed  of  by  an  arrangement  by  which  the  house  to  whom  a 
particular  contract  was  sold  substitutes  on  its  books  the  name  of-  a 
house  from  which  the  same  quantity  was  bought  by  the  house  which 
is  seeking  the  transfer,  and  similarly  the  house  from  which  it  was 
bought  substitutes  the  name  of  the  one  to  which  the  transferring  house 
has  sold.  Thus  if  in  the  case  illustrated  above  the  ring  broke,  say 
because  F  had  sold  to  G  instead  of  to  A  and  no  connection  from  G  to  A 
could  be  traced,  any  one  of  the  houses  except  A  and  G  could  be  released 
from  its  responsibility  by  transfer.  For  example,  B  might  effect  an 
arrangement  by  which  A  would  be  substituted  for  B  on  C’s  books  and, 
of  course,  C  on  A’s  books. 

The  principal  advantage  of  these  systems  of  reducing  the  number 
of  open  contracts  is  the  immense  saving  in  margins  which  results. 
So  long  as  contracts  remain  open  each  party  has  the  right  to  protection 
against  market  fluctuations  to  the  extent  of  io  per  cent,  so  that  if 
there  were  no  method  of  offsetting  the  trades  the  amount  so  tied  up 
during  the  course  of  a  season  would  grow  very  burdensome  to  the 
finances  of  the  commission  house. 

At  most  grain  exchanges1  a  more  complete  system  of  clearing  is 
in  use,  whereby  the  necessity  of  forming  rings  and  effecting  transfers 
is  eliminated,  and  each  house  is  responsible  only  to  protect  the  net 
balance  of  its  open  long  or  short  account  in  each  contract.  By  this 
method  each  house  reports  all  trades  daily  to  the  clearing  house, 
which  is  a  distinct  corporation,  and  then  substitutes  the  clearing  house 
on  its  books  for  the  house  with  which  the  trade  was  made.  Thus 
each  house  is  “long”  or  “short”  with  the  clearing  house  by  the  net 
amount  by  which  its  purchases  exceed  its  sales  of  the  given  contract, 
or  vice  versa,  while  the  clearing  house  itself  is  “  long  ”  with  some  houses 
exactly  the  amount  it  is  “short”  to  others.  Small  margins  are 
posted  by  members  with  the  clearing  house,  and  all  losses  or  gains 
from  fluctuations  in  price  of  the  open  contracts  are  settled  daily. 
Thus  if  A  has  sold  5,000  bushels  of  May  wheat  to  B  and  B  has  sold 
the  same  amount  to  C  the  clearing  house  will  be  “short”  to  C  and 
“long”  from  A.  If  during  the  life  of  the  option  the  market  price 
advances  two  cents,  A  must  pay  the  clearing  house  two  cents  a  bushel, 
or  $100,  and  C  is  entitled  to  withdraw  that  amount.  By  this  system 

1  The  system  here  described  is  frequently  referred  to  as  the  Minneapolis 
system. 


SPECULATION  IN  COMMODITIES 


213 


the  members  are  saved  a  vast  amount  of  labor  which  is  necessary  under 
the  Chicago  system,  and  the  amount  of  capital  tied  up  in  margins  is 
greatly  reduced. 

It  must  be  emphasized  that  all  these  provisions  have  to  do  with 
the  relations  of  members  of  the  exchange  with  one  another.  The 
customer  for  whose  account  a  trade  is  executed  has  nothing  to  do  with 
the  clearing,  ringing  out,  or  other  process  by  which  one  trade  open 
on  the  broker’s  books  is  offset  against  another.  Many  brokers  notify 
the  customer  of  the  name  of  the  member  with  whom  his  trade  was 
executed,  but  this  does  not  put  the  customer  into  any  direct  relation¬ 
ship  with  the  other  house  in  question.  When  a  customer  has  made  a 
trade  for  future  delivery  of  grain,  the  house  through  whom  he  has 
made  it  is  responsible  to  him  to  secure  delivery  or  acceptance  as  the 
case  may  be.  If  before  delivery  month  he  makes  an  offsetting  trade  in 
the  same  contract  through  the  same  broker  his  responsibility  is  ended; 
the  broker  must  secure  delivery  from  the  member  from  whom  he  has 
bought  and  make  delivery  to  the  one  to  whom  he  has  sold.  The  cus¬ 
tomer  is  allowed  to  withdraw  his  profits,  and  required  to  pay  his  losses, 
at  the  time  he  makes  his  closing  trade,  although  the  actual  delivery 
and  payment  on  the  contract  may  not  be  made  by  the  substituted 
parties  for  many  months. 

This  description  of  the  methods  used  in  disposing  of  contracts 
should  make  it  clear  that  immense  quantities  of  grain  can  be  bought 
and  sold  through  the  exchanges  with  a  very  small  amount  of  clerical 
and  administrative  labor  and  with  very  little  actual  transfer  of  pos¬ 
session.  The  process  by  which  the  total  volume  of  sales  can  be  made 
thus  to  exceed  by  many  times  the  amount  of  grain  actually  in  exist¬ 
ence  is  exactly  parallel  to  the  process  by  which  the  volume  of  cash 
payments  in  a  given  city  may  in  a  single  day  exceed  the  amount  of 
cash  held  by  the  banks  and  their  customers.  The  cash  payments  so 
largely  offset  one  another  that  only  a  small  percentage  of  checks 
involve  a  transfer  of  cash  from  one  bank  to  another.  In  exactly  the 
same  way,  the  system  of  offset  and  clearing  enables  the  trade  in  grain 
to  exceed  the  amount  of  grain  actually  held  for  delivery.  In  both 
cases,  the  soundness  of  the  system  depends  on  any  individual’s  being 
able  to  get  delivery  on  demand;  so  long  as  this  can  be  done  a  trade  in 
grain  is  no  more  fictitious  because  the  parties  to  the  trade  do  not 
handle  the  wheat  than  the  payment  of  a  debt  by  check  is  fictitious 
because  the  payee  does  not  have  the  actual  cash  transferred  from  the 
bank  on  which  the  check  is  drawn  to  the  one  in  which  he  deposited  it. 


214 


RISK  AND  RISK-BEARING 


*  The  methods  employed  in  other  commodity  futures  markets  are 
in  general  very  similar  to  those  which  have  been  described  in  connec¬ 
tion  with  the  Chicago  Board  of  Trade.  The  most  important  of  the 
smaller  grain  exchanges  are  those  of  Kansas  City  and  Minneapolis 
There  are  no  records  of  amounts  of  grain  sold  but  the  Federal  Trade 
Commission  has  prepared  estimates  based  on  the  volume  of  clearings. 
For  1916,  the  most  active  of  recent  trading  years,  the  estimates  are 
as  follows:  Chicago,  23.8  billion  bushels;  Minneapolis,  1.3  billion; 
Kansas  City,  1  billion. 

The  only  other  commodity  exchange  which  is  of  sufficient  impor¬ 
tance  to  warrant  attention  in  a  general  survey  of  the  speculative 
markets  is  the  New  York  Cotton  Exchange.  The  methods  of  operat¬ 
ing  through  this  market  are  not  materially  different  from  those  em¬ 
ployed  in  the  grain  exchanges.  The  unit  of  trading  is  100  bales  of 
middling  cotton  (each  bale  weighing  approximately  500  pounds).  As 
in  the  grain  markets,  the  contract  is  a  basis  contract,  the  seller  hav¬ 
ing  the  option  of  delivering  grades  above  or  below  middling  at  a  pre¬ 
mium  or  discount.  The  system  of  fixed  differences  has  never  worked 
as  satisfactorily  in  the  cotton  market  as  it  has  in  grain  markets,  ap¬ 
parently  because  the  differences  in  grade  are  of  more  importance  in 
determining  the  commercial  value  of  the  commodity,  and  because 
varying  weather  conditions  give  rise  to  very  wide  differences  in  the 
proportion  of  different  grades  produced  in  different  years.  Prior  to 
the  passage  of  the  United  States  Cotton  Futures  Act,  the  discounts 
and  premiums  were  fixed  by  a  committee;  at  present  they  are  fixed 
by  the  Secretary  of  Agriculture  on  the  basis  of  the  premiums  and 
discounts  actually  prevailing  in  a  large  number  of  selected  markets 
for  cash  cotton. 

Let  us  now  turn  our  attention  from  the  technical  organization 
and  procedure  of  the  exchange  to  the  speculator’s  methods  of  seeking 
profit  through  them.  Except  in  the  sensitiveness  of  the  market  to 
minor  influences  making  for  change,  the  ease  and  rapidity  with  which 
trades  can  be  effected,  and  the  small  amount  of  capital  needed  to 
control  comparatively  large  units  of  the  commodity  traded  in,  specu¬ 
lation  in  grain  or  cotton  through  the  futures  markets,  differs  little 
from  speculation  in  commodities  which  are  bought  and  sold  by  the 
ordinary  channels  of  trade.  In  all  forms  of  speculation  the  only  way 
in  which  the  operator  can  reasonably  expect  to  secure  a  profit  is 
through  some  sort  of  differential  advantage  over  the  market  as  a 
whole,  an  advantage  which  may  arise  either  from  special  training, 


SPECULATION  IN  COMMODITIES 


215 


unusual  ability  to  judge  the  trend  of  the  market,  or  from  access  to 
special  sources  of  information  not  available  to  the  general  public. 
Few  persons,  without  special  knowledge  of  the  businesses  in  which  the 
commodities  are  used,  suppose  that  they  can,  as  a  long  run  result, 
make  profits  by  speculating  in  such  commodities  as  lumber,  iron,  wool, 
or  silk,  though  these  commodities  have  active  markets  in  which  there 
are  unlimited  opportunities  for  profit  for  those  who  are  able  to  fore¬ 
cast  them.  But  thousands  of  people  who  would  never  consider  the 
advisability  of  buying  a  few  thousand  dollars  worth  of  any  of  these 
staples,  chiefly  on  credit,  and  holding  them  for  a  rise,  do  habitually 
or  occasionally  match  their  skill  against  the  market  for  speculative 
grains  and  cotton. 

The  reason  for  this  disposition  is  not  to  be  found  in  any  greater 
facility  for  forecasting  the  trend  of  the  market  in  the  case  of  the  or¬ 
ganized  than  in  the  unorganized  markets.  The  most  important  dif¬ 
ference  is  this,  that  in  an  organized  futures  market  the  commodity 
and  the  methods  of  buying  and  selling  it  are  so  standardized  that  it 
is  possible  for  an  individual  to  buy  and  sell  without  taking  the  trouble 
to  learn  the  technique  of  judging  qualities,  the  methods  of  handling 
and  storing,  the  trade  customs,  and  other  details  which  are  necessary 
for  buying  and  selling  through  the  unorganized  markets.  Add  to 
this  the  facts  that  the  amount  of  capital  required  is  very  small,  and 
that  the  markets  are  so  sensitive  that  profits  or  losses  can  be  realized 
very  quickly,  and  it  is  easy  to  see  why  organized  markets  attract  a 
following  of  speculators  who  are  affiliated  with  the  trade  in  the  commod¬ 
ity  in  no  other  way.  The  cotton  market  has  always  been  particularly 
popular  for  this  purpose  in  eastern  and  southern  circles  and  the  wheat 
market  in  the  Middle  West,  though  the  violence  of  fluctuation  of 
prices  during  the  war  and  the  closing  of  the  wheat  pit  during  the  period 
of  federal  control  caused  a  transfer  of  interest  to  the  corn  market, 
and  the  wheat  market  has  not  fully  recovered  its  following. 

What  then  are  the  methods  employed  by  speculators  in  these 
markets,  and  what  is  the  probability  of  success  in  using  those  methods  ? 
In  the  first  place,  it  is  certain  that  the  ease  with  which  trades  can  be 
executed  in  the  organized  markets  does  not  of  itself  imply  that  it  is 
any  easier  to  form  an  intelligent  judgment  of  the  probable  course  of 
prices  there  than  in  any  other  markets.  The  market  price,  whatever 
it  is,  represents  the  balance  of  judgment  of  the  trade,  both  speculative 
and  non-speculative,  as  to  the  figure  at  which  demand  and  supply 
will,  during  the  next  year  or  year  and  a  half,  be  approximately  equal. 


2l6 


RISK  AND  RISK-BEARING 


Analysis  of  the  conditions  of  demand  and  supply  is  a  special  problem 
for  each  commodity,  and  is  the  same  kind  of  problem  in  an  organized 
market  that  it  is  in  an  unorganized  market.  As  in  all  other  kinds 
of  speculation  the  average  result  for  the  whole  group  ol  speculators 
is  always  a  loss,  for  the  commissions  and  other  expenses  are  running 
against  the  public  just  as  the  percentage  in  favor  of  the  house  runs 
against  the  public  in  a  gambling  hell;  the  minority  who  succeed  do  so 
because  their  information  or  their  judgment  is  better  than  that  of  the 
market  as  a  whole.  The  first  question  which  the  prospective  specu¬ 
lator  should  ask  himself,  therefore,  is,  what  advantage  have  I  over 
the  average  man  who  trades  in  this  market?  If  he  has  no  definite 
advantage,  the  probability  is  that  his  chances  are  below  average,  for  he 
is  trading  in  a  market  where  there  are  many  men  with  life-long  train¬ 
ing  in  studying  market  conditions  and  with  access  to  the  resources  of 
large  organizations  for  compiling  crop  reports  and  trade  reports  which 
enable  them  to  anticipate  to  some  extent  the  reports  on  which  the  out¬ 
side  speculator,  the  average  man,  must  rely. 

This  advantage  of  the  professional  must  not  be  exaggerated,  how¬ 
ever.  The  saving  feature  of  the  situation,  from  the  standpoint  of 
the  average  speculator,  is  that  his  colossal  ignorance  of  the  factors 
which  he  needs  to  understand  in  order  to  forecast  the  trend  of  the 
prices  is  shared  to  a  large  extent  by  those  who  are  not  outsiders.  For 
though  it  is  clear  that  the  judgment  of  a  man  of  average  intelligence 
who  knows  nothing  of  the  grain  trade  is  not  likely  to  be  of  much  value 
in  forecasting  the  course  of  grain  prices,  the  converse  is  not  true.  A 
man  may  be  an  excellent  judge  of  the  qualities  of  grain  or  cotton,  or 
be  expert  in  transportation,  in  storage,  in  bargaining  with  country 
sellers,  or  in  a  dozen  other  ways  in  which  technical  proficiency  appears 
among  those  who  make  their  living  in  the  trade,  and  yet  he  may  have 
no  opinion  worth  quoting  in  regard  to  the  probable  future  trend  of 
prices.  The  market  is  too  big  to  be  judged  on  the  basis  of  the  facts 
which  come  to  the  attention  of  any  man  in  the  course  of  his  daily 
routine  unless  his  work  involves  constant  study  of  the  larger  factors 
which  determine  the  price  outlook.  And  there  are  large  “unknowns” 
for  the  most  careful  forecaster.  In  most  years  by  far  the  most  impor¬ 
tant  factor  in  making  and  breaking  prices  in  the  grain  and  cotton 
markets  is  the  crop  outlook.  Conditions  of  demand  are  relatively 
stable,  though  there  is  more  elasticity  in  the  demand  for  these  so-called 
necessities  than  is  generally  supposed.1 

1  For  evidence  of  this,  cf.  statistics  of  consumption  in  Report  of  the  Joint  Com¬ 
mission  of  Agricultural  Inquiry ,  Part  I,  chap.  viii. 


SPECULATION  IN  COMMODITIES 


217 


Conditions  of  supply  are  extremely  unstable,  on  the  other  hand, 
so  that  the  speculative  public  necessarily  takes  demand  more  or  less 
for  granted  and  concentrates  its  attention  on  supply.  This  does  not 
mean  that  changes  in  the  conditions  affecting  demand  are  less  influ¬ 
ential  than  supply  conditions  in  determining  the  price  at  which  the 
year’s  supply  will  move  into  consumption;  it  simply  means  that 
supply  conditions  are  discounted  in  the  price  long  before  they  actually 
materialize,  while  demand  conditions  are  reflected  in  prices  rather  at 
the  time  they  actually  occur.  For  a  large  part  of  the  year,  moreover, 
the  most  important  element  in  the  supply  problem,  the  future  course 
of  weather  conditions,  is  known  to  no  man.  The  same  thing  is  true, 
as  a  rule,  of  the  amount  of  acreage  which  will  be  planted  to  the  next 
year’s  crop  and  of  many  of  the  factors  of  demand.  Another  large 
part  of  the  necessary  data  for  judgment  consists  of  the  statistics  of 
visible  supply,  grain  in  farmers’  hands,  crop  conditions,  etc.,  which 
are  collected  by  government  bureaus  or  by  private  crop  reporting 
and  statistical  agencies,  and  are  available  to  the  general  public.  This 
is  the  great  argument  in  favor  of  speculation  in  the  grain  and  cotton 
markets  for  the  average  man  as  contrasted  with  the  stock  market. 
No  one  has  “inside  information”  concerning  the  weather  conditions 
next  month  or  the  crop  conditions  of  last  year.  The  factors  which 
are  known  to  all  and  the  factors  which  are  known  to  no  one  are  so 
important  that  the  factors  which  are  known  to  only  a  few  constitute 
a  less  crushing  handicap  against  the  outsider  and  give  him  something 
nearer  an  even  chance  to  save  his  money  than  he  has  in  the  stock 
market.  But  the  odds  are  against  him  in  either  place. 

The  methods  of  studying  the  factors  making  for  advance  or 
decline  of  prices  in  a  commodity  market  admit  of  no  such  precise 
analysis  as  was  attempted  in  our  discussion  of  the  technique  of  invest¬ 
ment  and  speculative  operations  in  the  security  markets.  To  a  large 
extent,  each  successive  price  situation  presents  a  new  problem.  In 
general,  the  factors  that  are  known  are  very  quickly  discounted  in  the 
price,  but  the  facts  essential  to  a  complete  solution  are  so  imperfectly 
known  that  there  is  a  wide  margin  of  variation  between  the  futures 
price  for  any  distant  month  and  the  prices  actually  realized  when 
that  month  arrives.  In  other  words,  the  trade  keeps  itself  well 
informed  on  the  situation,  at  least  the  supply  side  of  the  situation, 
at  any  given  time,  but  the  situation  is  so  frequently  changed  by  the 
appearance  of  new  and  unpredictable  conditions  that  futures  prices 
only  imperfectly  forecast  the  prices  that  will  be  charged  in  the  future. 


2l8 


RISK  AND  RISK-BEARING 


The  margin  of  error  in  the  calculations  of  the  market,  as  a  whole,  being 
so  large,  it  is  not  strange  that  it  is  wide  in  the  calculations  of  any 
individual  operator. 

Besides  the  general  common-sense  method  of  studying  the  whole 
situation  by  the  use  of  current  statistics  and  the  history  of  markets 
in  the  past,  a  number  of  special  methods  which  seek  to  isolate  single 
factors  and  predict  relatively  temporary  price  conditions  on  the  basis 
of  these  conditions,  may  be  mentioned. 

Calendar -trading  is  probably  more  prevalent  than  it  is  in  the  stock 
market,1  and  seems  rather  less  irrational  in  grain  or  cotton  than  in 
stocks.  No  careful  study  of  seasonal  tendencies  in  the  futures 
markets  seems  to  have  been  made,  however.2 

Weather  map-reading  is  an  effort  to  forecast  each  day’s  market  by 
study  of  the  daily  report  furnished  by  the  Weather  Bureau,  which 
shows  the  weather  conditions  for  all  parts  of  the  country  up  to  7:00 
a.m.  of  each  day,  before  the  opening  of  that  day’s  market.  The  under¬ 
lying  theory  of  the  map-reader  is  that  a  change  in  weather  which  will 
directly  affect  the  crop  prospects  in  any  section  is  likely  to  be  reflected 
immediately  in  buying  or  selling  orders  from  that  section,  which  may 
be  discounted  by  prompt  action  based  on  the  weather  report  itself. 
The  author  has  no  data  from  which  a  conclusion  can  be  drawn  con¬ 
cerning  the  degree  of  success  attainable  by  this  method  of  operation; 
it  seems  quite  possible  that  so  long  as  the  number  of  map-readers  is 
small  the  method  may  give  satisfactory  results.  A  general  adoption 
of  the  method  of  study  would  change  the  problem  to  that  of  making  a 
forecast  on  the  part  of  each  map-reader  of  what  the  other  map-readers 
are  likely  to  do. 

Pit-scalping  is  trading  on  the  floor  of  the  exchange  for  small  fluc¬ 
tuations,  largely  those  anticipated  on  account  of  situations  arising  on 
the  floor  itself;  it  is  very  similar  to  the  type  of  trading  referred  to  in 
connection  with  the  stock  market. 

Tailing  on  is  trading  on  gossip,  tips,  or  direct  information  con¬ 
cerning  the  market  position  of  leaders  in  the  trade.  This  is  apparently 
the  least  promising  method  of  all,  but  it  has  a  remarkable  number  of 
adherents,  if  one  may  judge  from  the  amount  of  attention  given  in 
the  market  gossip  to  the  doings  of  prominent  traders. 

1  See  p.  164. 

1  Tentative  studies  made  under  the  author’s  direction  indicate  that  there  are 
probably  some  seasonal  tendencies  in  futures  prices,  though  they  are  not  at  all 
comparable  in  scope  or  regularity  to  those  in  the  cash  grain  markets. 


SPECULATION  IN  COMMODITIES 


219 


Spreading  is  one  of  the  most  highly  specialized  types  of  speculation. 
This  consists  in  selling  one  contract  and  buying  another,  so  that  the 
profit  or  loss  will  consist  in  a  change  in  the  spread  between  the  two 
prices.  For  example,  a  trader  may  buy  December  wheat  in  Kansas 
City  and  sell  the  same  amount  of  December  wheat  through  the  same 
commission  house  in  Chicago.  The  two  trades  do  not  cancel  one 
another;  each  must  be  closed  out  later  by  a  separate  transaction.  But 
a  market  change,  due  to  most  causes,  will  affect  one  as  much  as  it 
will  the  other,  and  will  afford  neither  a  profit  nor  a  loss.  The  spreader 
speculates  only  on  the  factors  which  will  affect  one  price  more  than 
the  other,  such  as  an  interruption  of  traffic  on  account  of  a  car  shortage, 
or  crop  damage  in  the  north  occurring  after  the  southern  wheat  has 
passed  its  critical  point.  The  range  of  possible  variation  in  the  spread 
is  smaller  than  in  the  prices  taken  separately;  hence  the  commission 
house  can  safely  require  much  smaller  margins  than  woulc  be  required 
on  either  trade  alone.  For  this  reason  the  trader  can  operate  in  large 
units,  thereby  securing  a  compensation  for  the  narrowing  of  the  pos¬ 
sible  profit  per  bushel. 

In  like  manner,  one  may  buy  December  and  sell  May  futures  in 
the  same  market,  the  speculation  in  this  case  involving  the  premium 
or  discount  on  the  one  contract  compared  with  the  other.  Or,  one 
commodity  may  be  “spread”  against  another  commodity,  as  when 
corn  futures  are  bought  and  oats  futures  sold  at  the  same  time.  Most 
price  changes  in  the  corn  market  are  accompanied  by  similar,  though 
less  extensive,  movements  in  the  oats  market;  if  a  trader  foresees  a 
rise  in  corn  prices  which  will  not  affect  oats,  he  buys  the  corn  and  pro¬ 
tects  himself  by  the  short  sale  of  oats  against  changes  due  to  general 
conditions  affecting  both.  Or  the  spreader  may  be  simply  a  calendar- 
trader,  who  has  noticed  that  the  spread  has  moved  in  the  same  direc¬ 
tion  at  the  same  period  in  several  successive  years.1 

Since  commissions  on  spreading  trades  are  double  those  on  single 
trades  while  the  probable  profit  per  bushel  in  the  event  of  a  successful 
forecast  is  much  smaller,  the  commission  charges  are  a  heavy  handi¬ 
cap  against  the  spreader.  For  this  reason  such  transactions  are 
chiefly  those  of  exchange  members,  who  either  execute  their  own 
trades  or  pay  reduced  commissions. 

Unorganized  speculation  is  in  large  part  a  subsidiary  feature  of 
other  forms  of  business  enterprise.  A  speculative  element  is  present 

1  In  the  cotton  market,  spreads  between  different  markets  are  referred  to  as 
straddles;  in  the  grain  trade,  the  latter  term  is  frequently  applied  to  trades  in 
which  one  month’s  contract  is  bought  and  another  month  sold  short  against  it. 


2  20 


RISK  AND  RISK-BEARING 


in  all  lines  of  business  where  goods  must  be  held  for  resale,  unless  the 
risk  can  be  eliminated  by  hedging  or  by  “contracting  out.”  Hedging 
will  be  discussed  in  chapter  xii;  contracting  out  was  discussed  in 
chapter  iv.  In  connection  with  the  latter  discussion,  attention  was 
called  (p.  61)  to  the  possibility  of  keeping  price  risk  at  a  minimum 
by  carrying  small  inventories  and  balancing  advance  sales  against 
purchases. 

Business  men  who  believe  themselves  able  to  prognosticate  price 
changes  frequently  pursue  the  opposite  course  to  that  just  indicated, 
increasing  inventories  when  they  believe  prices  are  about  to  advance 
and  cutting  them  down  in  anticipation  of  falling  prices.  To  what¬ 
ever  extent  this  policy  is  practiced,  the  business  assumes  the  char¬ 
acter  of  a  speculation  on  price  changes,  and  all  that  has  been  said 
concerning  the  difficulty  of  profiting  consistently  through  any  sort 
of  speculation  applies  to  it  in  full.  Wherever  success  depends  on  skill 
in  forecasting  the  course  of  a  market  it  resolves  itself  into  a  problem 
of  being  more  skilful  or  more  fortunate  than  the  group  whose  composite 
judgment  makes  the  level  of  prices  what  it  is,  and  speculation  in  inven¬ 
tory,  except  that  it  is  not  so  rapid,  is  quite  as  risky  as  speculation  in 
futures. 

Of  the  specific  types  of  unorganized  speculation,  only  one  need 
be  given  special  attention — the  trade  in  land.  For  many  generations 
this  has  been  the  favorite  American  speculation,  and  its  risks  are  still 
generally  supposed  to  be  less  than  is  the  case  with  any  other  form  of 
speculative  enterprise.  As  with  other  lines  of  unorganized  specula¬ 
tion,  land  speculation  is  largely  a  side  issue  to  other  lines  of  business, 
in  this  case  chiefly  agriculture  and  building,  though  there  is  also  a 
considerable  volume  of  speculative  buying  and  selling  by  individuals 
who  have  no  business  need  to  become  land-owners. 

As  compared  with  the  organized  markets  described  above,  land 
speculation  presents  the  following  peculiarities: 

i.  There  is  no  “short  side.”  In  any  epoch  of  land  speculation, 
the  bulls,  therefore,  have  full  control  so  long  as  their  enthusiasm  and 
capital  suffice  to  support  and  advance  the  market.  Those  who  believe 
land  is  going  higher,  buy;  those  who  believe  it  is  going  lower,  except 
as  they  happen  to  be  owners  of  land  which  they  can  sell  out,  have  no 
influence  on  the  situation.  Hence,  in  land  booms,  prices  rise  more 
sharply  than  is  likely  to  be  the  case  in  almost  any  other  form  of  specu¬ 
lation.  On  the  other  hand,  when  prices  once  turn  downward  there 


SPECULATION  IN  COMMODITIES 


221 


are  no  “shorts”  who  must  come  into  the  market  as  buyers  sooner 
or  later,  and  the  lack  of  this  kind  of  buying  makes  the  collapse  more 
complete  and  sudden  than  is  likely  to  be  the  case  after  the  completion 
of  a  boom  in  an  organized  market. 

2.  The  turnover  is  relatively  slow.  Whereas  the  grain  speculator 
can  enter  into  a  trade,  or  close  it  out,  on  a  minute’s  notice,  real  estate 
often  must  be  held  a  long  time  till  a  buyer  appears. 

3.  Prices  are  relatively  steady.  Except  in  occasional  booms, 
there  are  few  fluctuations,  and  prices  generally  show  an  upward  trend 
from  year  to  year.  The  apparent  steadiness,  however,  is  less  signif¬ 
icant  than  it  appears,  as  it  is  largely  due  to  the  slowness  of  turnover 
previously  referred  to.  Speculative  buyers  of  real  estate  expect  to 
have  to  hold  their  properties  a  considerable  length  of  time;  hence  are 
not  apt  to  be  caught  in  positions  where  they  must  sell  quickly  at  any 
price.  Nominal  prices  remain  steady  at  times  when  few  or  no  sales 
are  occurring,  and  when  a  real  market  could  be  established  only  by 
drastic  reductions  in  prices. 

4.  Real  estate  speculation  requires  proportionately  more  capital  than 
does  organized  speculation.  Whereas  stocks  and  futures  can  be  bought 
and  sold  on  margins  of  10  per  cent  or  less,  the  buyer  of  real  estate  must 
usually  be  prepared  to  advance  at  least  one-third  the  purchase  price. 
Hence  proportionate  changes  in  price  mean  proportionately  smaller 
profits  and  losses.  This  factor,  together  with  those  referred  to  in  the 
two  preceding  paragraphs  (slow  turnover  and  steady  prices),  accounts 
for  the  somewhat  smaller  proportion  of  speedy  failures  among  those 
who  dabble  in  real  estate  speculation  as  compared  with  stock  specu¬ 
lation  or  the  trade  in  grain  futures. 

5.  Individual  judgment  of  qualities  of  land  and  individual  skill  in 
bar  gaming  play  a  large  part  in  determining  success.  In  an  organized 
market,  anyone  may  know  at  a  glance  at  what  price  his  commodity 
is  selling  and  may  confidently  expect  to  buy  or  sell  at  practically  the 
same  price  as  anyone  else  would.  In  the  land  market,  no  two  units 
are  alike;  trades  are  infrequent;  the  prices  actually  paid  are  often 
not  made  public.  Hence  there  is  an  opportunity  for  a  good  judge  of 
values  to  profit  by  trading  with  poorer  judges,  quite  apart  from  changes 
in  the  level  of  prices  of  other  land  in  the  same  vicinity.  For  the  same 
reason  the  element  of  skill  in  “dickering”  often  makes  the  difference 
between  a  profit  and  a  loss. 

6.  Profits  are  very  generally  overestimated.  When  land  is  used  for 
agricultural  purposes  by  the  owner  during  the  life  of  his  speculation, 


222 


RISK  AND  RISK-BEARING 


or  is  rented,  a  nominal  profit  on  resale  often  represents  a  real  loss  if 
account  is  taken  of  the  fact  that  the  property  has  failed  to  yield  a  fair 
return  on  the  original  investment  during  the  time  it  was  held.  Agri¬ 
cultural  land  in  the  eastern  corn  belt  before  the  war  generally  returned 
less  than  3  per  cent  on  its  sale  value,  if  rented,  or  if  worked  by  the 
owner  with  proper  allowance  for  the  value  of  his  own  time.  In  most 
localities  this  situation  was  not  greatly  changed  by  the  war  boom, 
as  land  prices  and  rents  and  prices  of  farm  products  all  advanced, 
leaving  the  net  return  on  the  sale  price  more  irregular  than  before, 
but  probably  on  the  average  still  less  than  3  per  cent.  In  such  cases 
the  excess  of  the  selling  price  over  the  figure  on  which  a  fair  return 
can  be  earned  represents  a  capitalization  of  anticipated  future  returns, 
either  in  increased  direct  yield  or  in  the  price  secured  on  resale.  In 
many  cases  apparently  high  prices  paid  for  land  have  in  fact  been 
justified  by  the  appearance  of  the  anticipated  increases,  yet  the  profit 
on  resale  has  no  more  than  compensated  for  the  loss  of  interest  during 
the  years  the  property  was  held. 

In  the  case  of  urban  land  held  vacant  for  resale,  the  point  just 
made  is  still  more  pertinent.  Apart  from  considerations  of  taxation, 
unused  land  must  double  in  value  every  twelve  years  to  yield  on  resale 
a  return  of  6  per  cent  on  the  investment.  Urban  lands  held  out  of  use 
for  speculative  purposes  apparently  do  not,  on  the  average,  increase 
in  value  at  as  great  a  rate  as  that,  and  6  per  cent  is  certainly  a  low 
return  for  a  speculative  transaction.  Some  individual  pieces  of  land 
improve  much  more  rapidly,  and  many  fail  to  gain  for  years  at  a  time. 
In  other  words,  the  “unearned  increment”  is  not  something  which 
accrues  automatically  as  a  result  of  investment  in  land,  but  is  like 
any  other  speculative  gain,  a  differential.  Such  a  differential  gain 
may  be  obtained  by  superior  shrewdness  in  forecasting  the  lines  along 
which  a  city  will  develop,  by  “inside  information”  concerning  the 
plans  of  municipal  governments,  corporations,  and  individuals,  or  by 
sheer  good  luck.  Its  existence  in  any  case,  however,  is  always  a  result 
of  uncertainty,  for  just  as  in  every  other  case  where  future  income 
is  capitalized,  as  soon  as  an  increase  in  the  value  at  a  known  future 
date  becomes  certain  it  is  immediately  reflected  in  the  present  price, 
and  the  income  no  longer  represents  more  than  pure  interest  on  the 
selling  price.1 

1  The  social  interest  in  the  activities  of  the  land  speculator  is  discussed  below, 
chap,  xviii. 


CHAPTER  XII 


HEDGING 

Among  the  institutions  which  have  been  developed  to  aid  the  busi¬ 
ness  man  in  avoiding  the  risks  incident  to  our  roundabout  time-con¬ 
suming  methods  of  production  and  distribution,  one  of  the  most  inter¬ 
esting  is  the  system  of  shifting  the  risks  of  price  changes,  which  is  made 
possible  through  the  use  of  the  futures  markets  for  “hedging  ”  purposes. 
A  hedging  transaction  may  be  defined  as  a  coincident  purchase  and 
sale  in  two  markets,  which  are  expected  to  behave  in  such  a  way  that 
any  loss  realized  in  one  may  be  offset  by  an  equivalent  gain  in  the  other. 

As  applied  in  the  grain  and  cotton  futures  market,  the  term 
“hedging”  refers  to  one  of  two  types  of  transactions.  The  first,  the 
hedging  sale,  arises  when  a  country  grain  dealer,  a  terminal  buyer,  a 
miller,  or  an  exporter  buys  grain  in  the  cash  market  and  sells  futures 
contracts  of  an  equivalent  amount,  as  protection  against  a  fall  in  price 
during  the  time  that  the  grain  is  in  his  possession.  The  second,  the 
hedge  purchase,  arises  when  a  manufacturer  has  sold  his  product 
ahead  at  a  fixed  price  and  buys  futures  to  protect  himself  against  an 
advance  in  the  price  of  raw  material.  The  idea  is  that  if  the  price  of 
cash  grain  declines  a  similar  decline  will  probably  occur  in  the  futures 
market,  and  the  loss  realized  on  the  one  transaction  will  be  offset  by  a 
gain  realized  on  the  other.  It  goes  without  saying  that  such  a  pro¬ 
tection  cannot  be  obtained  without  giving  up  the  chances  of  a  profit 
from  a  price  fluctuation  in  the  opposite  direction.  Since  the  hedging 
transaction  involves  some  costs  for  commissions,  taxes,  interest  on 
margins,  etc.,  it  is  clear  that  the  average  result  of  a  long  series  of  such 
trades  should  normally  be  a  slight  loss,  but  this  loss  is  regarded  as  a 
premium  paid  for  insurance  against  the  risk  of  such  heavy  losses  in  an 
unfavorable  season,  as  would  disrupt  the  business  and  prevent  its 
continuance  through  the  long  run,  in  which  gains  and  losses  from 
price  changes  could  be  expected  to  balance. 

The  question  may  arise,  why  any  individual  would  engage  in  trans¬ 
actions  of  such  a  character  that  the  chances  of  loss  and  the  chances  of 
gain  offset  one  another.  The  answer  is  that  in  changing  grain  from 
country  points  to  terminal  markets,  in  milling,  in  jobbing  flour,  and 
in  other  operations  incident  to  the  production  and  distribution  of 


223 


224 


RISK  AND  RISK-BEARING 


grain  production,  the  trade  or  manufacturing  profit  can  be  expected 
under  ordinary  conditions  of  competition  without  reference  to  any 
gain  or  loss  from  price  changes.  The  hedge  enables  the  operator  to 
make  his  price  and  regulate  his  business  on  the  basis  of  his  ordinary 
trade  profit,  without  the  possibilities  of  speculative  loss  or  gain  which 
arises  from  the  instability  of  prices.  It  is  impossible  to  carry  on  such 
operations  as  these  without  owning  grain  or  its  products  through 
a  certain  period  of  time,  but  the  hedge  enables  the  operator  to  isolate 
the  ordinary  risks  of  competition  from  the  special  risks,  which  arise 
from  the  instability  of  prices  of  the  commodities  in  which  he  is 
dealing. 

Several  advantages  result  from  such  a  separation.  For  one  thing, 
the  amount  of  credit  which  the  grain  or  other  operator  can  secure  is 
much  greater.  This  is  true  because  the  protection  afforded  a  bank  by 
the  use  of  warehouse  receipts  for  grain  as  collateral  is  much  stronger, 
in  case  the  owner  is  protected  against  loss  by  hedging  contracts.  The 
principle  is  the  same  as  that  involved  in  the  custom  by  which  the 
mortgagors  are  required  to  keep  property  insured  for  the  benefit  of 
mortgagees.  In  the  second  place,  the  use  of  the  hedging  contract 
makes  it  possible  to  do  business  on  a  much  smaller  margin  of  profit. 
Where  hedging  contracts  are  not  available,  commodities  must  be 
handled  on  a  wide  enough  margin  to  compensate  for  the  risk  of  adverse 
price  changes.  When  the  protection  of  the  hedging  contract  is  avail¬ 
able,  competition  ordinarily  brings  about  a  narrowing  of  the  profit 
margin  in  accordance  with  the  reduced  amount  of  risk.  This  is  of  no 
financial  advantage  to  the  grain  dealers  as  a  class,  but  makes  it 
possible  for  consumers  to  receive  the  benefit  of  lowered  prices,  or  grain 
producers  to  receive  the  benefit  of  higher  prices,  or  for  both  these 
things  to  take  place,  and  it  also  makes  the  grain  dealers’  business  less 
speculative. 

It  is  clear  that  the  gains  from  the  practice  of  hedging  are  entirely 
due  to  the  reduction  of  uncertainty,  and  not  to  any  reduction  in  the 
probability  of  the  unfavorable  contingency  against  which  protection 
is  sought.  Whenever  a  man  saves  himself  from  loss  by  hedging 
through  the  futures  market,  someone  has  to  lose  to  keep  him  even.  The 
question  therefore  arises  whether  the  total  amount  saved  by  hedgers 
as  a  group  on  transactions,  where  they  would  otherwise  incur  loss,  is 
greater  or  smaller  than  the  profits  they  lose  in  cases  where  the  market 
moves  in  their  favor.  The  theory  generally  accepted  among  econo¬ 
mists  is  that  the  speculators  w’ho  buy  and  sell  hedges  to  grain  dealers, 
millers,  and  other  tradesmen  are  specialists  in  the  art  of  discounting 


HEDGING 


225 


the  future,  more  expert  than  those  with  whom  they  are  dealing,  and 
that  hedgers  as  a  class,  therefore,  lose  something  in  the  long  run  to 
the  speculators  as  a  class.  This  loss  constitutes  the  compensation 
of  the  speculators  for  the  service  of  reducing  trade  risk,  and  from  the 
standpoint  of  the  grain  trader,  should  be  figured  like  his  commissions, 
as  a  premium  paid  for  insurance  against  risks  too  great  to  be  borne. 

No  statistics  bearing  on  this  question  are  available,  but  it  does 
not  seem  probable  that,  as  a  matter  of  fact,  speculators  are  more  expert 
than  the  dealers  with  whom  they  trade.  Grain  dealers,  millers,  and 
others  who  habitually  hedge  probably  stay  in  business  much  longer  on 
the  average  than  do  speculators,  and,  therefore,  accumulate  more 
experience.  The  speculative  group  includes  a  certain  number  of 
professional  large-scale  operators  who  do  succeed  in  staying  in  business 
year  after  year,  and  presumably  are  making  satisfactory  profits,  but 
these  are  the  survivors  of  a  large  number  whose  financial  strength  is 
exhausted,  or  whose  taste  for  speculation  is  satisfied  before  they  attain 
the  dignity  of  professionals.  A  few  speculators  make  very  large  prof¬ 
its,  but  in  all  probability  the  business  of  furnishing  hedging  contracts 
belongs  in  the  list  of  services  which,  as  a  whole,  are  rendered  for  society 
without  compensation.1  Another  point  which  is  frequently  over¬ 
looked  in  the  discussing  of  hedging  is  the  question  to  what  extent 
hedging  contracts  and  practice  furnish  protection  against  price  changes. 
The  following  selection  summarizes  the  situation  in  this  regard : 

It  has  been  the  common  custom  in  works  dealing  with  market 
risks  and  their  elimination  to  mention  hedging  contracts  as  one  of 
the  most  effective  social  devices  for  reducing  and  transferring  risk. 
There  is  in  these  discussions  usually  the  implication,  if  not  the  definite 
statement,  that  hedging  contracts,  wherever  they  can  be  used  at  all, 
can  be  expected  to  give  a  complete  protection  to  the  user  against 
the  risk  of  adverse  price  changes.2  Such  conclusions  concerning 
hedging  transactions,  as  they  are  carried  on  in  the  ordinary  course 
of  business  through  the  futures  markets,  are  not  at  all  justified.  They 
arise  from  an  inadequate  comprehension  of  the  nature  of  a  hedging 

1  See  above  p.  38. 

2  For  example:  “Whatever  it  (the  milling  company  which  sells  hedges) 
gains  or  loses  on  the  original  purchase  of  cash  wheat  will  be  exactly  offset  by  an 
equal  loss  or  gain  on  the  future  sale.”  F.  M.  Taylor,  Principles  of  Economics , 
p.  294.  “A  person  who  is  neither  long  nor  short  is  running  no  risk;  he  is  hedged.” 
J.  E.  Boyle,  Speculation  and  the  Chicago  Board  of  Trade ,  p.  34.  “If  wheat  prices 
have  risen  he  loses  on  his  wheat  ‘deal’  but  this  loss  is  offset  by  the  corresponding 
rise  in  flour.”  Marshall  and  Lyon,  Our  Economic  Organization,  p.  382. 


226 


RISK  AND  RISK-BEARING 


contract  or  from  an  incomplete  understanding  of  the  relations  of  the 
two  markets  which  are  essential  to  the  hedging  process. 

To  see  clearly  the  possibilities  and  limitations  of  hedging  con¬ 
tracts  on  organized  produce  markets  it  is  necessary  to  understand 
first  what  a  hedging  contract  is.  The  essence  of  a  hedging  contract 
is  a  coincident  purchase  and  sale  in  two  markets  which  are  expected 
to  behave  in  such  a  way  that  any  loss  realized  in  one  will  be  offset  by 
an  equivalent  gain  in  the  other.  If  such  behavior  follows  a  perfect 
hedge  has  been  effected.  The  commonest  type  of  hedging  transaction 
is  the  purchase  and  sale  of  the  same  amount  of  the  same  commodity 
in  the  spot  and  in  the  futures  markets.  Frequently,  however,  the 
trades  are  in  different  commodities,  as  when  cottonseed  oil  is  hedged 
in  the  lard  market  or  flour  in  the  wheat  market.1 

The  spot  and  the  futures  markets  are  separate  markets.  The  futures 
market  is  highly  centralized  and  highly  competitive.  All  futures 
transactions  are  made  in  a  dozen  exchanges,  where  buying  and  selling 
orders  converge  from  all  over  the  world.  The  “spot  market,”  on  the 
other  hand,  if  it  can  be  spoken  of  as  a  market  at  all,  is  highly  decen- 
.  tralized,  frequently  only  partially  competitive,  and  much  less  respon¬ 
sive  to  minor  forces  making  for  change.  Spot  trades  which  it  is  desir¬ 
able  to  hedge  take  place  in  Gopher  Prairie  as  well  as  on  the  floor  of 
the  Minneapolis  Chamber  of  Commerce.  The  exporter  in  Baltimore 
and  the  miller  in  Painted  Post  may  be  as  anxious  to  hedge  purchases 
or  sales  as  is  the  terminal  elevator  operator  who  buys  on  the  floor  of  the 
Chicago  Board  of  Trade.  In  speaking  of  the  spot  market  we  may  be 
talking  about  the  market  in  any  one  of  many  places.  Whereas  an 
almost  perfect  system  of  communication  has  made  the  futures  markets 
practically  a  unit,  the  separate  spot  markets  are  at  best  only  partially 
merged  into  one. 

Any  divergence  from  the  anticipated  relationship  of  the  prices  in  the 
two  markets  results  in  an  imperfect  hedge.  The  possibility  of  imper¬ 
fection  in  the  protection  offered  by  hedging  trades  has  been  recognized 
by  some  few  writers,  but  through  all  the  literature  of  marketing  there 
runs  the  assumption  that  such  variations  as  make  the  protection 

1  The  distinction  drawn  here  is  somewhat  artificial,  as  it  rarely  happens  that 
the  commodities  bought  and  sold  in  the  spot  and  futures  markets  respectively  are 
actually  identical.  Only  specific  “contract  grades”  are  sold  through  the  futures 
market,  and  these  are  not  likely  to  be  the  exact  equivalent  of  the  spot  purchases 
which  are  being  hedged.  The  imperfect  character  of  the  protection  offered  by 
hedging  sales  in  the  case  of  “off  grades”  is  indicated  in  J.  E.  Boyle,  op.  cii., 
pp  171-75- 


HEDGING 


227 


inadequate  are  much  more  abnormal  and  infrequent  than  is  actually 
the  case.1 

THE  ASSUMPTION  OF  A  NORMAL  SPREAD 

The  failure  to  appreciate  the  varying  relationship  between  spot 
and  future  prices  and  the  resulting  erroneous  notions  concerning 
hedging  have  centered  about  the  idea  of  a  “normal  spread,”  that  is,  a 
relationship  between  spot  and  future  prices  which  is  believed 
to  show  itself  with  a  high  degree  of  regularity.  It  is  obvious 
that  if  any  definite  spread  between  the  spot  and  the  futures  price 
does  appear  with  great  frequency  and  permanence  the  hedger  is 
relatively  safe  in  assuming  that  the  two  prices  will  fluctuate  in  uni¬ 
son,  and  may  place  his  hedge  with  the  expectation  of  correspond¬ 
ingly  complete  protection  from  adverse  changes  in  price.  The  nor¬ 
mal  spread  has  been  assumed,  however,  without  a  careful  analysis 
of  the  assumptions  that  would  be  necessary  to  make  it  a  useful  con¬ 
cept.  A  presentation  of  the  assumptions  which  are  necessary  to  give 
meaning  to  the  idea  will  show  the  fallacy  of  the  notion  of  complete 
insurance  against  price  changes  and  at  the  same  time  furnish  a  back¬ 
ground  against  which  the  actual  happenings  and  the  resultant  possi¬ 
bilities  of  avoiding  market  risk  by  hedging  may  be  shown  more  clearly. 

Coincident  fluctuations  in  any  two  markets  can  be  expected  only 
under  one  of  two  sets  of  circumstances.  In  the  first  place,  the  two 
markets  might  conceivably  remain  in  line  with  one  another  because 
both  were  controlled  by  the  same  forces,  or  second,  prices  in  one  market 
might  exercise  a  controlling  influence  over  prices  in  the  other.  In 
practice  neither  of  these  things  ever  happens  completely  in  connection 
with  the  spot  and  futures  markets  of  the  produce  trades.  To  show 
what  does  happen,  it  is  necessary  first  to  consider  the  hypothetical 
conditions  under  which  a  perfect  hedge  could  be  effected;  second, 
to  analyze  the  ways  in  which  the  actual  marketing  situation  diverges 

1  For  example:  “There  is  every  reason  to  believe  that  if  the  price  of  cash 
wheat  rises  10  cents  a  bushel  the  September  option  will  also  have  a  rise  of  10  cents, 
or  approximately  that  amount.”  S.  S.  Huebner,  “The  Functions  of  Produce 
Exchanges,”  Annals  of  the  American  Academy  of  Political  and  Social  Science , 
XXXVIII  (1911),  343.  Fred  M.  Clark  {Principles  of  Marketing ,  pp.  370-72) 
recognizes  the  possibility  of  a  situation  in  which  futures  contracts  do  not  offer  a 
complete  hedge,  but  seems  to  regard  this  situation  as  highly  exceptional.  L.  D 
H.  Weld  {Marketing  of  Farm  Products ,  p.  345)  refers  to  the  failure  of  hedges  to 
offer  complete  protection  on  account  of  the  tendency  of  futures  and  cash  prices  to 
draw  together  as  delivery  day  approaches.  When  futures  contracts  are  selling 
above  cash  grain  this  is  a  source  of  gain  to  sellers  of  hedges  against  grain  in  storage 
or  in  process  of  manufacture.  For  its  effect  on  buyers  of  hedges  against  forward 
sales  of  flour,  cf.  below,  p.  256. 


228 


RISK  AND  RISK-BEARING 


from  these  hypothetical  conditions;  and  third,  to  survey  the  statisti¬ 
cal  evidence  concerning  the  frequency  of  occurrence  of  the  conditions 
under  which  a  perfect  hedge  can  be  secured.  The  wheat  trade  furnishes 
a  convenient  case  for  both  the  assumed  and  the  actual  illustrations. 

A  SUPPOSITITIOUS  SITUATION 

Let  us  begin  our  discussion  by  considering  a  highly  artificial  and 
simplified  situation  in  which  there  would  be  a  definite  normal  relation¬ 
ship  between  the  prices  of  wheat  for  immediate  delivery  and  for  deliv¬ 
ery  at  any  specified  future  date.  We  shall  assume: 

1.  That  there  is  no  carry  over;  that  is,  the  last  bushel  of  the  old  crop 
has  gone  out  of  the  market  at  the  end  of  the  crop  year,  say  on  June  30. 

2.  That  the  entire  new  crop  of  the  world  has  “come  in”  at  one 
time,  July  1,  and  is  accessible.  In  practice  this  would  doubtless  have 
to  mean  that  a  very  large  portion  of  it  had  reached  central  markets 
where  it  could  be  retained  as  a  visible  supply,  and  there  would  have  to 
be  no  doubt  that  the  balance  of  it  could  be  made  available  without 
delay  when  wanted  for  consumption. 

3.  That  no  additional  wheat  could  possibly  reach  the  market 
until  July  1  of  the  following  year. 

4.  That  costs  of  storing  grain  do  not  change  during  the  year. 

5.  That  everyone  who  is  interested  in  the  wheat  trade  has  full 
information  concerning  the  available  supply. 

6.  That  everyone  in  the  wheat  trade  has  complete  information 
concerning  the  fact  that  wheat  is  to  be  consumed  uniformly  through¬ 
out  the  year  and  at  such  a  rate  as  exactly  to  exhaust  the  supply  on 
June  30. 

7.  That  everyone  concerned  can  be  counted  on  to  act  with  pecu¬ 
niary  rationality.1 

With  these  conditions  existing,  one  might  expect  to  find  a  defi¬ 
nite  and  normal  relation  existing  at  any  given  time  between  the  spot 
and  the  futures  contract  prices,  and  an  absolute  uniformity  in  the 
price  of  each  futures  contract  throughout  its  life.  The  situation 
which  would  exist  on  July  1  is  illustrated  in  Figure  1  as  follows: 

XA  =  price  of  cash  wheat  on  July  1. 

YC—  price  of  June  futures  on  July  1. 

Successive  ordinates  ol  AC  represent  successive  prices  of  cash  wheat 
through  the  year. 

1  Most  of  these  considerations  would  be  included  in  the  statement  that  the 
supply  is  known  and  that  the  effective  demand  is  such  that  the  total  will  be  con¬ 
sumed  during  the  year  and  at  a  uniform  rate.  It  has  seemed  well,  however,  to 
put  the  situation  in  factual  terms  so  far  as  possible. 


HEDGING 


229 


AM,  AF ,  AH,  AD  represent  the  carrying  charges  to  September  30, 
December  31,  May  31,  and  June  30. 

XM,  XF,  XH,  represent  the  prices  of  September,  December,  and 
May  futures;  these  prices  are  constant. 

Since,  according  to  the  assumptions,  the  supply  is  known,  its 
availability  certain,  its  total  consumption  fixed  at  a  uniform  rate,  and 
all  persons  concerned  are  acting  rationally,  the  price  on  July  1  of  wheat 
deliverable  the  30th  of  the  following  June  would  be  higher  by  exactly 
the  carrying  charge  between  the  two  dates.1  The  price  of  cash  wheat 
would  increase  uniformly  from  the  beginning  to  the  end  of  the  year. 

If  at  any  time  the  “spread”  between  spot  and  future  prices  should 
exceed  the  amounts  indicated  there  would  be  an  immediate  and  cer¬ 
tain  profit  for  anyone  who  would  buy  cash  grain,  sell  futures,  put  the 
grain  in  storage,  and  later  deliver  it  on  the  contracts.  Under  these 
conditions  no  one  could  rationally  sell  any  cash  grain.  If,  on  the 
other  hand,  the  spread  became  less  than  the  carrying  charge  it  would 
be  unprofitable  for  anyone  to  hold  any  grain,  for  it  would  be  cheaper 
to  sell  one’s  holdings  and  replace  them  by  purchasing  futures  and 
accepting  delivery  on  them. 

,  A  MODIFICATION  OF  THE  ASSUMPTIONS 

We  may  now  modify  our  assumptions  and  bring  them  closer  to 
reality  by  introducing  certain  factors  which  may  operate  to  disturb 
the  price  level.  Suppose  there  occurs  a  general  decrease  in  the 
desire  to  consume  wheat,  on  account  of  the  introduction  of  a  popular 
substitute.  Or,  a  more  probable  occurrence,  suppose  it  is  discovered 
during  the  year  that  the  size  of  the  crop  has  been  underestimated. 
Retaining  our  hypotheses  of  complete  information  and  of  the  necessity 
of  getting  rid  of  the  entire  crop  by  July  1,  it  is  obvious  that  the  price 
of  wheat  must  immediately  fall  to  a  figure  which  will  stimulate  con¬ 
sumption  sufficiently  to  move  the  entire  crop  into  consumption  by 
June  30.  There  is  no  reason  to  suppose  that  such  a  change  would 
affect  the  premium  on  futures  over  spot  prices.  The  triangle  ABC  in 
Figure  1  would  move  toward  the  line  XY,  decreasing  both  XA  and 
XD,  but  AD  would  be  unchanged.  In  like  manner  changes  in  the 
proportion  of  the  crop  desired  for  consumption  early  in  the  year, 
changes  in  costs  of  production,  and  many  other  factors  which  affect 
prices  would  have  the  same  effect  on  both  spots  and  futures.  Even 

1  The  important  factors  in  the  carrying  charge  are,  of  course,  storage,  interest, 
nsurance,  and  shrinkage. 


230 


RISK  AND  RISK-BEARING 


the  introduction  of  a  carry  over  into  the  scheme  would  not  alter  the 
relationship  of  cash  and  future  prices,  so  far  as  deliveries  in  the 
same  crop  year  are  concerned  (though  it  would  have  a  marked  effect 
on  the  relation  of  cash  prices  in  the  spring  and  futuies  prices  for  new 
crop  deliveries). 

If,  however,  we  assume  that,  on  account  of  ignorance  or  economic 
irrationality  or  on  account  of  physical  difficulties  in  getting  the  crop 
to  market,  the  holders  of  a  large  part  of  the  supply  fail  to  sell  it  during 
the  first  half  of  the  year  and  then  dump  it  on  the  market  for  consump¬ 
tion  during  the  last  half,  the  case  is  entirely  different.  The  only 


Fig.  i 

possible  result  of  this  situation  will  be  higher  cash  prices  during  the 
first  half  of  the  year  than  during  the  last  half;  if  the  buyers  of  forward 
contracts  understand  the  situation  futures  prices  for  spring  deliveries 
will  correspond  to  the  lower  prices  which  will  actually  prevail  at  deliv¬ 
ery  dates. 

The  result  is  illustrated  in  Figure  2  as  follows: 

As  before, 

XA  =  cash  price  in  July. 

FC  =  cash  price  in  following  June. 

XD— price  of  June  futures  in  July. 

The  prices  of  intermediate  futures  will  be  such  as  to  reflect  the 
anticipated  course  of  the  cash  grain  market.  AC  will  not  necessarily 
be  straight,  and  may  be  of  any  degree  of  irregularity,  except  that  it 


HEDGING 


231 


cannot  drop  below  the  level  of  DC  by  more  than  the  carrying  charges 
to  June  30  from  the  time  represented  by  the  point  of  intersection. 

Under  such  conditions  the  market  would  afford  very  imperfect 
facilities  for  hedging. 

The  premium  DA  on  cash  grain  over  futures  contracts  is  sure 
to  disappear.  Hence  the  hedger,  if  he  holds  grain  long,  must  expect 
to  lose,  either  by  an  advance  in  the  price  of  the  futures  contract  which 
he  is  “ short,”  or  by  a  decline  in  the  cash  grain  which  he  is  ‘Tong”  or 
by  both.  There  is  no  inducement  to  hold  grain  longer  than  is  neces¬ 
sary.1 

Such  a  situation  as  this  seems  on  the  face  of  things  to  be  highly 
abnormal,  and  the  discussions  which  postulate  the  possibility  of  a 


complete  hedge  simply  assume  that  the  condition  depicted  in  Fig¬ 
ure  1  is  “normal”  and  that  in  Figure  2  abnormal.  Our  next  task, 
therefore,  is  to  examine  the  extent  to  which  the  terms  “normal” 
and  “abnormal”  have  any  real  application  to  the  varying  spreads 
between  spot  and  futures  prices. 

In  the  first  place,  it  must  be  emphasized  that  the  current  assump¬ 
tions  concerning  normal  spreads  do  not  apply  to  the  relation  between 
spot  prices  for  old  wheat  near  the  end  of  the  crop  year  and  contract 
prices  for  new  crop  deliveries.  Let  us  examine  the  factors  which 

1  Of  course  if  DX  is  large  relatively  to  DA  it  may  be  profitable  for  those  whose 
business  requires  them  to  own  grain  at  such  times  to  sell  hedges  against  it.  The 
hedge  increases  the  probability  of  a  small  speculative  loss,  which  must  be  covered 
by  a  trade  profit,  but  protects  against  a  large  loss  due  to  changes  in  other  fundamen¬ 
tal  conditions  which  affect  cash  and  futures  prices  alike. 


232 


RISK  AND  RISK-BEARING 


determine  the  relative  value  in  May  or  June  of  wheat  for  immediate 
and  for  future  delivery.  Consider  first  the  influence  of  the  amount 
of  old  wheat  on  hand.  So  far  as  the  spot  market  is  concerned,  this 
constitutes  the  entire  potential  supply,  and  its  relation  to  the  demand 
for  wheat  for  immediate  consumption  is  the  most  important  factor 
in  determining  prices.  So  far  as  the  July  or  September  prices  are 
concerned,  on  the  other  hand,  the  supply  of  old  wheat  is  of  importance 
only  as  it  affects  estimates  of  the  total  which  will  be  available  for 
comsumption  during  the  coming  year,  of  which  total  the  carry  over 
of  old  wheat  will  constitute  only  a  small  fraction.  More  specifically, 
if  in  May  or  June  the  supply  of  old  wheat  is  small  relatively  to  the 
amount  needed  to  keep  mills  in  operation  and  supply  current  demands 
for  flour  till  the  new  wheat  is  fit  for  grinding,  the  spot  prices  at  terminal 
markets  will  have  very  little  relation  to  the  futures  prices.  On  the 
other  hand,  if  the  supply  of  old  wheat  is  large  enough  so  that  a  consid¬ 
erable  part  is  likely  to  be  carried  over  to  be  sold  along  with  the  new 
wheat,  the  spot  price  will  come  under  the  control  of  the  factors  which 
determine  the  price  of  the  futures  and  is  colloquially  said  to  be  con¬ 
trolled  by  the  futures.  In  other  words,  a  shortage  of  old  wheat  may 
send  the  spot  price  to  a  level  indefinitely  higher  than  the  price  for 
futures,  but  an  abundance  of  old  wheat  cannot  send  it  lower  than  the 
futures  price,  except  by  the  “  carrying  charge,”  because  the  surplus 
of  old  wheat  constitutes  a  part  of  the  prospective  supply  which  deter¬ 
mines  the  price  of  the  futures. 

Spot  prices  at  different  points  which  are  not  centers  of  consumption 
are  affected  differently  by  a  shortage  of  old  wheat  near  the  end  of  the 
season.  If  there  are  supplies  quite  near  the  terminal  markets,  and 
the  situation  is  not  complicated  by  the  presence  of  a  local  consumptive 
market,  their  price  will  be  closely  related  to  the  spot  prices  at  the  ter¬ 
minals.  If  there  are  other  supplies  so  remote  that  they  cannot  be 
gotten  to  the  central  market  before  new  wheat  is  expected,  their 
price  fluctuations  will  correspond  to  those  for  the  futures.  In  general, 
the  longer  the  time  required  to  make  delivery  at  a  central  market  or  a 
point  of  consumption,  the  lower  the  spot  price  will  be,  provided  the 
futures  are  selling  below  the  cash  grain. 

The  spread  between  spot  and  future  prices  is  the  most  obvious 
instrument  which  society  uses  to  control  the  carry  over  of  grain  from 
one  crop  year  to  another.  If  large  offerings  of  old  wheat  or  a  prospec¬ 
tive  shortage  of  new  results  in  a  premium  on  future  contracts  large 
enough  to  cover  the  full  cost  of  carrying,  storage  is  encouraged;  if  a 


HEDGING 


233 


shortage  of  old  wheat  or  the  prospect  of  a  large  new  crop  results  in 
cash  prices  higher  than  futures,  or  even  above  the  figure  where  the 
premium  on  the  futures  will  cover  carrying  costs,  holders  are  encour¬ 
aged  to  market  their  holdings  of  old  and  replace  them  by  purchases 
of  futures.  The  social  utility  of  an  adjustment  of  prices  which  will 
effect  a  distribution  of  the  old  grain  between  the  two  crop  years  in 
accordance  with  the  relations  of  present  and  prospective  demand  and 
supply  conditions  is  obvious,  and  in  general  the  system,  though  imper¬ 
fect,  seems  fairly  effective.  The  usual  situation  is  a  premium  on 
cash  over  the  futures.1  If  the  market  always  behaved  in  a  perfectly 
rational  way  a  very  small  premium  on  spots  over  futures  would  suffice 
to  insure  that  no  grain  would  be  carried  forward  beyond  the  amounts 
actually  needed  to  supply  demands  for  old  grain  before  the  new  became 
fully  equivalent  in  quality;  for  no  one  could  afford  to  carry  forward 
for  sale  in  a  future  month  a  commodity  which  he  could  more  economi¬ 
cally  buy  for  delivery  in  that  month.  Some  grain  is  carried  over, 
however,  especially  by  farmers,  in  excess  of  what  is  needed,  and  in  the 
face  of  a  practical  certainty  of  lower  prices  in  the  fall.2 

The  situation  during  the  fall  months  is  apparently  simpler  than 
that  which  exists  before  the  harvest,  and  the  expression  “normal 
spread”  has  more  meaning,  but  even  here  there  is  no  uniformity  in  the 
spreads  between  cash  and  futures  markets  in  different  years.  In  the 
assumed  setting  given  earlier  we  have  seen  how  “a  normal  spread” 
might  be  made  possible.  But  the  marketing  of  grain  is  so  irregular 
that  there  occurs  surprisingly  often  a  relative  shortage  of  cash  grain 
and  surplus  of  prospective  supply.  Given  a  certain  state  of  demand, 
the  price  of  futures  tends  at  this  time  of  the  year  to  be  controlled  by 

1  To  test  this  point  an  examination  was  made  of  the  prices,  at  Chicago,  of  cash 
contract  wheat  and  July  futures  on  the  first  trading  day  in  May  for  the  years  1901 
to  1915  inclusive.  Of  the  fifteen  years  there  were  twelve  in  which  at  the  respective 
low  prices  of  the  day  cash  grain  was  above  the  July  option  at  its  low  point  and  only 
one  (1907)  in  which  the  premium  on  July  futures  over  cash  grain  was  as  much  as 
2  cents.  The  figures  for  the  low  prices  of  the  day  represent  the  situation  more 
accurately  than  those  for  the  daily  high  prices,  because  the  futures  price  always 
represents  the  bottom  of  the  grade,  while  the  cash  quotation  may  represent  any 
quality  not  quite  good  enough  to  be  classed  in  the  next  higher  grade.  Accurate 
data  as  to  carrying  costs  are  not  at  hand,  but  figuring  interest  at  6  per  cent  on 
90  cents  a  bushel  and  storage  at  1914  rates  the  cost  of  these  two  items  approxi¬ 
mated  1.8  cents  for  the  first  month  and  1.5  cents  a  month  thereafter. 

2  An  extreme  case  occurred  in  the  late  spring  of  1915,  when  many  farmers  were 
holding  grain  for  a  rise,  although  September  wheat  was  selling  from  30  to  40  cents 
and  July  wheat  from  15  to  25  cents  below  the  cash  quotations. 


234 


RISK  AND  RISK-BEARING 


the  reported  size  of  the  harvest,  while  the  spot  price  depends  upon  the 
supply  of  grain  actually  available.  Whenever,  on  account  of  bad 
roads,  car  shortage,  railway  strikes,  farmers’  holding  movements,  or 
for  other  reasons,  the  supply  of  grain  actually  coming  into  the  central 
markets  is  smaller  than  current  reports  concerning  the  size  of  the  har¬ 
vest  led  the  trade  to  expect,  the  spot  price  rises  above  so-called  “  nor¬ 
mal”  relation  to  the  futures.  A  premium  on  cash  over  futures  is  a 
very  common  phenomenon.  For  example,  on  the  first  trading  day  in 
November  from  1901  to  1915  the  lowest  price  of  spot  contract  grain 
in  Chicago  wras  higher  than  that  of  May  futures,  six  times,  and  in 
only  three  years  out  of  the  fifteen  was  the  May  future  as  much  as 
seven  cents  higher  than  the  cash.1 

Even  during  the  spring  months,  when  we  should  expect  the  closest 
correspondence  between  the  spot  and  the  futures  markets,  there  is 
no  discernible  tendency  for  the  futures  prices  to  equal  the  cash  price 
plus  a  carrying  charge.  From  1901  to  1915  there  were  only  nine 
years  in  which  at  their  respective  low  points  on  the  first  trading  day  of 
March  the  May  future  was  higher  than  the  cash  contract  wheat.  A 
similar  situation  prevailed  in  other  markets.  Comparison  of  the 
lowest  prices  for  cash  contract  oats  and  for  May  futures  on  the  first 
trading  day  in  April,  for  the  years  1901  to  1915,  gives  the  following 
results:  May  price  higher,  four  times;  lower,  nine  times;  the  same, 
once;  data  insufficient,  once.  Examination  of  figures  for  corn  prices 
has  also  failed  to  show  any  tendency  for  the  futures  to  run  uniformly 
above  the  cash.2 

It  is  therefore  clear  that  any  attempt  on  the  part  of  a  miller  or 
other  hedger  to  make  money  by  taking  off  hedges  when  the  spread  is 
abnormal  is  purely  a  speculation.3  No  one  can  ever  predict  from  the 
quotations  themselves  what  either  the  cash  markets  or  the  futures 
markets  will  do.  All  that  can  be  said  is  that  the  two  markets  will 
come  together  by  the  last  day  of  the  month  of  delivery,  but  whether 

1  Data  from  Howard  Bartels’  Red  Books. 

2  Data  from  sources  previously  cited. 

3  The  following  passage  reflects  a  misunderstanding  on  the  point  which  seems 
to  be  widespread:  “Terminal  elevators  sometimes  increase  their  profit  by  buying 
in  their  hedge  at  times  when  the  spread  narrows  more  than  is  normal.  This  will 
increase  their  profits,  because,  as  it  will  be  remembered,  the  spread  at  the  time 
they  bought  cash  wheat  and  sold  it  for  future  delivery  was  enough  to  cover  the 
costs  of  carrying  it  in  addition  to  some  profit.  And  so,  if  the  spread  at  the  time  of 
sale  has  narrowed  more  than  the  normal  amount,  the  profit  is  increased  by  so  much. 
They  can  buy  again  when  the  spread  becomes  normal.”  Fred  E.  Clark,  op.  cit ., 
P.  372. 


HEDGING 


235 


the  spread  will  disappear  by  .a  rise  of  the  lower  price  or  a  fall  of  the 
higher,  or  a  rise  or  fall  of  both  with  one  moving  more  than  the  other, 
is  a  question  for  the  speculator. 

The  only  element  in  the  entire  relationship  of  the  spot  and  futures 
which  may  be  called  a  ‘‘control”  is  the  fact  that  at  any  given  time 
the  futures  prices  cannot  get  above  the  spot  prices  by  materially  more 
than  the  carrying  charge  from  the  date  in  question  to  the  date  of 
delivery.  This  is  true  because  of  the  possibility  previously  noted  of 
buying  grain  in  the  spot  market,  selling  futures  to  the  same  amount, 
carrying  until  the  delivery  date,  and  delivering  the  actual  grain.  The 
profit  of  any  trader  doing  this  would  consist  of  the  difference  between 
the  carrying  charge  (plus  commissions  and  other  charges)  and  the 
premium  on  futures  over  spot  prices  at  the  time  he  made  the  two  con¬ 
tracts.  Such  operations  would  at  once  narrow  the  spread  by  forcing 
spot  prices  up  and  future  prices  down. 

In  this  same  connection,  however,  it  is  worthy  of  notice  that  it  is 
not  to  be  expected,  even  if  grain  is  marketed  freely,  that  the  futures 
contract  prices  for  all  deliveries  or  for  any  two  deliveries  will  fully 
discount  the  carrying  charge  between  them.  If  the  spread  between 
the  December  and  the  May  futures  at  any  time  is  fully  equal  to  the 
cost  of  carrying  from  December  to  May,  any  speculator  may  buy 
December  grain  and  sell  the  same  amount  of  May,  knowing  that  the 
spread  will  not  become  wider,  to  his  detriment,  and  may  become 
narrower,  to  his  profit.  A  speculation  offering  a  chance  of  profit  and 
no  chance  of  loss,  even  if  the  chance  of  profit  is  not  great,  is  an  ideal 
speculation,  and  the  competition  of  speculators  to  buy  the  nearer  and 
sell  the  more  distant  future  is  bound  to  be  sufficient  to  make  such  a 
situation  quite  abnormal  and  only  of  momentary  duration.  Spreads 
between  futures  contracts  vary  widely.1 

The  carrying  charge  bears  exactly  the  same  relation  to  the  move¬ 
ment  of  grain  into  storage  and  out  into  the  channels  of  consumption 
which  the  cost  of  shipping  gold  bore  to  the  movement  of  specie  in 
international  trade  in  the  days  before  the  war,  with  this  important 
exception,  that  whereas  gold  could  be  shipped  in  either  direction, 
grain  can  be  carried  forward  for  future  consumption  but  cannot  be 

1  The  price  of  May  wheat  at  its  low  point  on  November  15.  or  the  next  trading 
day  of  the  years  indicated,  varied  from  the  low  figure  for  December  wheat  on  the 
same  date  by  the  following  amounts:  1908,  4^  cents  higher;  1909,  if  cents  lower; 
1910,  5s  cents  higher;  1911,  6*  cents  higher;  1912,  55  cents  higher,  1913,  4! 
cents  higher;  1914,  6|  cents  higher;  1915,  if  cents  higher.  For  data  on  carrying 
charges  see  notes  above,  pp.  229  and  233. 


236 


RISK  AND  RISK-BEARING 


transported  back  into  the  past.  Hence,  as  just  noted,  the  premium 
on  futures  over  spot  cannot  exceed  the  carrying  charge,  but  the 
premium  on  spot  over  futures  has  no  limit,  while  in  the  gold  trade 
a  shift  in  the  premiums  could  cause  a  movement  in  either  direction, 
so  that  the  premium  and  the  discount  on  foreign  exchange  both  had 
definite  limits. 

CONCLUSIONS 

In  the  light  of  these  conditions,  the  limitations  of  the  hedging 
market  are  clear.  Whenever  the  cash  price  is  above  the  futures,  or 
below  the  futures  by  less  than  a  full  carrying  charge,  there  is  no  such 
thing  as  a  complete  hedge  for  cash  grain  purchases.  If  the  cash  grain 
and  the  futures  contract  are  selling  at  the  same  price,  and  the  carrying 
charge  till  delivery  month  is  four  cents  a  bushel,  the  hedging  con¬ 
tract  will  afford  the  buyer  of  cash  grain  complete  protection  against 

losses  of  more  than  four  cents  a  bushel.  Losses  of  less  than  that 

« 

amount  are  rendered  less  probable,  for  there  are  many  price  changes 
due  to  causes  which  affect  both  markets  alike,  and  against  these  the 
hedge  is  complete.  But  there  is  always  the  risk  that  the  markets  will 
diverge  to  the  extent  permitted  by  the  carrying  charge. 

It  remains  to  consider  the  case  for  the  hedge  buyer,  for  example 
the  man  who  has  contracted  to  deliver  flour  at  a  fixed  price  in  the 
future  and  buys  futures  to  protect  himself  against  a  rise  in  prices. 
If  his  selling  prices  for  flour  were  based  on  the  cash  prices  at  times  when 
the  futures  prices  were  lower,  he  would  make  an  extra  profit  without 
risk  by  buying  the  futures  to  cover  his  needs.  Under  the  ordinary 
conditions  of  competition,  however,  it  is  clear  that  sales  of  flour  for 
distant  future  delivery  must  be  based  on  futures  prices  for  wheat; 
hence  the  purchase  of  futures  is  as  good  a  hedge  when  futures  are  below 
the  spot  prices  as  when  they  are  above. 

Sellers  of  flour  and  similar  products  who  protect  their  forward 
contracts  by  purchases  of  future  contracts  secure  complete  protection 
if  they  can  wait  till  delivery  date  before  securing  their  raw  material 
and  can  use  the  grades  of  grain  which  are  tendered  on  contracts,  but 
if  they  must  purchase  at  intermediate  dates  their  protection  is  only 
partial,  as  the  spot  market  in  which  they  must  buy  their  supplies  may 
advance  without  limit  above  the  futures  price.1 

‘Adapted  by  permission  from  C.  O.  Hardy  and  L.  S.  Lyon,  “The  Theory  of 
Hedging,”  Journal  of  Political  Economy,  XXXI  (April,  1923),  276-87. 


CHAPTER  XIII 


LIFE  INSURANCE 

The  subject-matter  of  this  chapter  is  discussed  in  terms  of  the 
following  outline: 

I.  Introductory  considerations 

II.  The  risk  insured 

III.  Policy  contracts 

1.  General  classification  of  policies 

2.  Classification  according  to  conditions  of  maturity 

3.  Classification  according  to  premium  payments 

4.  Classification  according  to  number  insured 

5.  Classification  according  to  right  to  share  in  profits 

6.  Standard  policy  conditions 

IV.  Insurance  company  organization 

V.  Selection  of  risks 

VI.  Calculation  of  premiums 

1.  Mortality  tables 

2.  Interest  rates 

3.  Net  premium,  annual  renewable  term  policy 

4.  Net  single  premium,  whole  life  insurance 

5.  Level  annual  premiums 

6.  Comparison  of  costs  of  various  types  of  policy 

7.  Loading 

VII.  Disbursement  of  life  insurance  funds 

1.  Expenses 

2.  Settlement  of  claims 

3.  Cash  surrender  values 

4.  Policy  loans 

5.  Dividends 

VIII.  Special  types  of  life  insurance 

1.  Group  insurance 

2.  Industrial  insurance 

3.  Fraternal  and  assessment  insurance 

4.  Annuities 

5.  War  risk  insurance 

I.  INTRODUCTORY  CONSIDERATIONS 

As  was  indicated  in  chapter  iv,  the  most  important  method  of 
getting  rid  of  risk  in  business  affairs  through  transfer  to  others  is  the 


237 


238 


RISK  AND  RISK-BEARING 


institution  of  insurance.  In  the  same  chapter,  reference  was  made 
also  to  the  character  of  the  insurance  contract  as  an  agency  for  reducing 
risk  through  combination,  through  special  knowledge  on  the  part  of 
insurers,  and  through  preventive  activity  on  their  part.  No  further 
attention  need  be  given  the  social  theory  of  insurance  here  except  to 
point  out  a  contrast  between  life  insurance  and  other  forms  of  insur¬ 
ance. 

In  general,  the  theory  of  insurance  is  that  the  insured  obtains 
a  hedge  against  a  contingency  which,  if  it  occurs,  will  cause  him 
actual  financial  loss;  and  that  contracts  which  purport  to  insure 
against  a  contingency  involving  no  financial  loss  to  the  buyer  of  the 
insurance  partake  of  the  nature  of  gambling  transactions.1 

The  chief  practical  consequences  of  this  are,  first,  the  doctrine 
of  insurable  interest,  under  which  the  person  seeking  to  effect  insur¬ 
ance  is  required  to  show  that  he  has  an  actual  interest  in  the  event 
insured  against,  and  second,  the  disapproval  of  overinsurance.  In 
many  lines  of  insurance,  the  liability  of  the  insurer  is  limited  to  the 
amount  of  loss  actually  realized,  regardless  of  the  amount  of  insur¬ 
ance  carried;  and  in  practically  all  lines  effort  is  made  by  insurers 
to  limit  insurance  to  the  amount  of  risk  actually  undergone  by  the 
insured.  In  life  insurance,  however,  the  principle  of  indemnity  can 
receive  only  partial  application.  The  doctrine  of  insurable  interest 
applies,  but  where  an  actual  financial  interest  exists,  insurers  cannot, 
for  obvious  reasons,  insist  on  insurance  being  limited  rigidly  to  the 
amount  of  the  actual  risk.  The  value  of  a  man’s  life  is  too  delicate  a 
question  to  be  made  readily  the  subject  of  contractual  stipulation. 
Moreover,  an  individual  is  always  held  to  have  insurable  interest  in 
his  own  life;  hence  he  is  free  to  obtain  insurance  and  to  make  it  pay¬ 
able  to  whom  he  pleases,  without  regard  to  the  character  of  the 
beneficiary’s  interest.2 

In  spite  of  this  fact,  from  the  standpoint  of  the  insured  and  his 
dependents,  the  question  as  to  what  financial  hazard  is  involved  in 
his  life  risk  is  as  vital  as  in  any  other  type  of  insurance.  Insurance 
up  to  the  amount  required  to  place  the  beneficiaries,  in  the  event  of 

1  The  reader  will  not  fail  to  note  the  sharp  contrast  in  this  respect  between  the 
theory  of  insurance  and  of  hedging.  In  speculative  futures  markets,  while  the 
hedging  function  is  generally  asserted  to  constitute  the  chief  social  justification 
of  the  system,  the  question  whether  a  given  individual  in  operating  through  the 
market  has  an  actual  risk  to  hedge  does  not  in  any  way  affect  the  legitimacy  of 
his  operations. 

2  This  is  not  true  of  the  insurance  written  by  the  so-called  fraternal  orders. 


LIFE  INSURANCE 


239 


the  death  of  the  insured,  in  the  same  financial  position  they  would 
have  been  had  he  lived,  is  a  hedge,  and  its  purchase  up  to  this  amount 
may  be  sound  investment  policy;  insurance  in  excess  of  that  amount  is 
a  speculation,  and  a  poor  speculation  at  that,  for  the  premiums  are 
always  so  adjusted  that  the  odds  are  in  favor  of  the  insurer. 

n.  THE  RISK  INSURED 

One  of  the  first  questions  which  arises,  therefore,  in  connection 
with  life  insurance  pertains  to  the  character  of  the  risk  against  which  a 
hedge  is  sought.  The  similar  question  which  arises  in  connection 
with  other  types  of  insurance  is  comparatively  simple,  but  the  loss 
due  to  the  death  of  a  given  individual  is  not  susceptible  of  such 
exact  determination  as  is  possible  with  most  types  of  loss. 

What  then  is  the  measure  of  the  value  of  a  human  life?  A 
moment’s  consideration  will  show  that  the  amount  of  the  risk  on  a 
given  man’s  life  is  not  closely  related  to  the  needs  of  those  who  are 
dependent  upon  him.  The  primary  object  of  insurance  is  like  the 
objective  of  any  other  business  transaction  which  looks  to  the  future, 
that  is,  not  to  provide  the  minimum  amount  on  which  a  family  can 
survive,  but  to  provide  the  maximum  which  can  be  secured  without 
a  cost  in  present  sacrifices  in  excess  of  its  value. 

The  principles  upon  which  a  correct  estimate  of  the  value  of  a 
man’s  life  must  be  based  are  exactly  the  same  as  those  governing  the 
value  of  any  other  source  of  income.  The  financial  value  of  a  man’s 
life  is  the  present  worth  of  the  total  amount  of  money  which  he  may 
be  expected  to  earn  during  the  period  of  his  normal  working  life 
minus  the  present  worth  of  the  total  amount  of  money  which  he  may 
reasonably  be  expected  to  expend  for  personal  consumption.  That  is, 
if  a  man  will  earn  on  the  average  during  the  next  five  years  $5,000  a 
year  but  will  spend  $2,000  a  year  for  personal  consumption  or  for 
other  expenses  which  will  normally  be  stopped  in  case  of  his  death, 
the  net  loss  to  his  family  from  his  death  will  be  $3,000  a  year  for  the 
five  years,  and  the  equivalent  iii  cash  at  the  present  time  will  be  the 
present  worth  of  a  five-year  annuity  of  $3,000,  or,  at  3  per  cent, 
$r3, 739.ro.  If  his  normal  working  life  is  more  than  five  years,  or  if 
his  probable  earnings  above  personal  expenditures  will  vary  during  the 
period,  the  calculation  is  more  complicated,  but  the  principle  remains 
the  same.  This  does  not  mean,  however,  that  the  family  need  be 
protected  by  a  whole  life  policy  for  the  amount  indicated.  If  a  man 
is  assumed  to  earn  $2,000  per  year  above  his  maintenance  from  age 


240 


RISK  AND  RISK-BEARING 


thirty-five  to  age  sixty-five,  the  present  worth,  at  5  per  cent  of  his 
life  at  age  thirty-five  is  about  $30,745,  but  a  year  later  the  value  will 
be  only  $30,282.  There  will  then  be  only  twenty-nine  years  of  work 
left  in  him  instead  of  thirty,  and  his  value  must  be  written  down  for 
this  “  depreciation. ”  On  the  other  hand,  the  present  worths  of  the 
earnings  of  all  the  subsequent  years  must  be  written  up  to  take 
account  of  the  shorter  period  for  which  they  are  now  to  be  discounted, 
so  that  the  actual  decrease  in  his  capitalized  earning  power  is  not 
$2,000  but  $463. 

In  the  case  of  policies  taken  out  for  business  purposes,  a  different 
test  of  the  amount  at  risk  must  be  applied.  Such  policies  are  of 
several  types.  Sometimes  insurance  is  carried  by  partners  on  one 
another’s  lives.  Sometimes  a  corporation  carries  insurance  on  the 
life  of  its  president  or  other  valued  executive.  In  both  cases  the 
object  of  the  insurance  is  to  offset  the  risk  of  loss  to  the  business 
through  disruption  of  the  management.  Sometimes  insurance  is 
carried  on  the  lives  of  employees  under  contract,  whose  services  are 
of  such  a  specialized  character  and  whose  abilities  are  so  rare  that  it 
would  be  difficult  to  replace  them.  Baseball  players  and  artists 
are  frequently  so  insured  for  the  benefit  of  their  employers. 

In  all  these  cases  the  amount  at  risk  must  be  estimated  by  deduct¬ 
ing  from  the  value  of  the  services  rendered  the  salary  or  other  com¬ 
pensation  which  is  being  paid  or  is  anticipated  to  be  paid  during  the 
probable  continuance  of  the  business  relationship.  In  the  case  of  an 
executive  whose  personal  fortunes  are  bound  up  with  the  future  of 
the  insuring  corporation  or  partnership,  the  value  of  the  services  may 
properly  be  capitalized  for  the  whole  business  life  of  the  insured,  or  a 
substantial  portion  thereof;  in  the  case  of  employees  under  contract, 
only  the  services  to  be  rendered  during  the  term  of  the  contract  should 
be  considered.  Estimating  the  value  of  services,  particularly  where 
the  services  consist  in  large  part  of  the  use  of  one’s  name,  is  very 
difficult,  but  an  approximation  may  be  effected  stating  the  question 
in  this  way:  How  much  additional  salary,  above  that  now  paid  or 
expected  to  be  paid,  could  the  organization  afford  to  pay  rather  than 
be  deprived  of  the  services  ? 

Another  type  of  business  policy  is  that  taken  out  to  protect  the 
interest  of  a  creditor  in  the  life  of  a  debtor.  When  the  debtor  pays  the 
insurance  premiums  as  a  means  of  securing  credit,  which  is  the  usual 
situation,  the  amount  at  risk  is  simply  the  amount  of  the  debt,  plus 
any  accretions  of  interest  which  may  arise  during  the  period  con- 


LIFE  INSURANCE 


241 


templated.  If,  however,  the  insurance  is  effected  by  the  creditor 
and  he  pays  the  premiums,  or  desires  to  obtain  sufficient  insurance 
to  protect  him  in  case  he  is  compelled  to  pay  premiums  in  order  to 
prevent  lapse,  a  situation  arises  which  has  been  the  source  of  much 
confusion.  It  has  been  held,  and  the  courts  have  at  times  sustained 
the  view,  that  in  this  case  there  is  an  insurable  interest  amounting  to 
the  principal  of  the  debt  plus  the  premiums  which  the  creditor  would 
have  to  pay  if  he  kept  the  insurance  alive  through  the  probable  life 
of  the  debtor,  plus  interest.  This  appears  plausible,  but  it  is  utterly 
impossible  of  application,  for  the  reason  that  no  matter  whether  the 
insurance  be  large  or  small  in  amount,  it  will  inevitably  be  exceeded 
by  the  amount  of  premiums  required  to  keep  it  in  force  through  the 
life  expectancy  of  the  insured,  with  interest.  If  this  were  not  true, 
the  contract  would  be  an  impossible  one  for  the  insurance  company 
to  fulfil. 

in.  POLICY  CONTRACTS 

The  contract  of  life  insurance  is  expressed  in  a  document  known  as 
a  policy.  The  life  insurance  policy  is  distinguished  from  most  other 
types  of  contract  by  the  following  peculiarities.  First,  it  is  a  uni¬ 
lateral  contract.  That  is,  the  insured  may  cancel  the  contract  at 
any  time,  and  under  certain  conditions  may  even  recover  a  portion 
of  what  he  has  paid  under  its  terms,  while  the  insurance  company 
has  no  such  option,  but  is  bound  by  the  contract  so  long  as  the  insured 
fulfils  his  obligations. 

Second,  although  the  contract  is  an  agreement  between  two  parties, 
the  insurer  and  the  insured,  there  is  usually  involved  a  third  party, 
known  as  the  beneficiary,  to  whom  the  insurance  is  payable  in  the 
event  of  the  death  of  the  insured  within  the  life  of  the  contract. 
Though  not  a  party  to  the  contract,  the  beneficiary  may  have  title 
to  the  policy.  Whether  this  is  the  case  depends  on  the  form  of  the 
contract.  If  the  policy  contains  what  is  known  as  a  “change  of 
beneficiary  clause,”  that  is,  a  clause  giving  the  insured  the  right  to 
change  the  beneficiary  at  will,  the  title  vests  in  the  insured,  and  he 
may  be  required  to  assign  it  for  the  benefit  of  creditors  in  the  event 
of  his  own  insolvency.  If  there  is  no  such  clause,  the  beneficiary’s 
consent  is  necessary  for  a  change  of  beneficiary,  and  creditors  have  no 
claim  to  the  surrender  value  of  the  policy.  In  either  event,  under  the 
laws  of  most  states,  the  proceeds  of  a  policy  payable  to  wife  or  children, 
if  matured  by  death  of  the  insured,  are  not  liable  for  the  debts  of  the 
insured,  even  though  he  was  insolvent  at  death.  Nor  can  such 


242 


RISK  AND  RISK-BEARING 


funds,  as  a  rule,  be  seized  by  creditors  of  a  widow  or  minor  children, 
so  long  as  they  are  not  mingled  with  other  funds  which  are  subject 
to  such  seizure. 

A  third  peculiarity  of  the  life  insurance  policy  contract  is  the  high 
degree  of  standardization  which  it  displays.  The  details  differ  widely 
from  one  company  to  another,  but  the  most  important  features  of  the 
contracts  written  by  one  company  are  almost  identical  with  those 
written  by  another,  so  that  it  is  possible  to  classify  and  describe  them 
almost  without  reference  to  the  peculiarities  of  practice  of  different 
companies.1 

The  standard  types  of  policy  may  be  classified  on  any  one  of  several 
bases,  as  is  indicated  in  the  following  outline: 

CLASSIFICATION  OF  LIFE  INSURANCE  AND  ENDOWMENT  POLICIES 

I.  According  to  conditions  of  maturity 

1.  Term  insurance 

2.  Whole  life  insurance 

3.  Endowment  life  insurance 

4.  Pure  endowments 

5.  Life  annuities 

6.  Life  insurance  with  disability  provisions 

II.  According  to  method  of  payment  of  premiums 

1.  Single  premium  * 

2.  Limited  payment  life 

3.  Level  premium 

4.  Natural  premium 

III.  According  to  number  of  insured  persons 

1.  Individual 

2.  Joint  life 

3.  Group 

IV.  According  to  type  of  insurer 

1.  “Old  line”  or  legal  reserve  policies 
*  2.  Fraternal  benefit  certificates 

3.  Assessment  agreements 

4.  Government  (war  risk)  policies 

5.  Miscellaneous  agreements  of  insurance 

V.  According  to  the  right  of  the  insured  to  share  in  profits  of  the  insurer 

1.  Participating 

2.  Non-participating 

1  This  statement  refers  particularly  to  the  contracts  written  by  so-called  olu 
line  insurance  companies.  Fraternal  and  assessment  insurance,  which  differ 
radically  from  other  types  of  life  insurance,  are  discussed  below. 


LIFE  INSURANCE 


243 


Let  us  consider  first  the  classification  according  to  conditions  of 
maturity. 

.  A  term  insurance  policy  is  a  pure  insurance  contract.  It  provides 
insurance  for  a  stipulated  term  of  years,  for  a  premium  which  may  be 
paid  either  in  advance  or  in  a  series  of  annual,  semiannual,  or  quarterly 
payments.  In  case  of  lapse,  there  is,  as  a  rule,  no  refund  to  the  insured, 
and  in  case  of  expiry  before  the  death  of  the  insured  the  obliga¬ 
tion  of  the  insurer  ceases.  Renewable  term  policies  have  the  additional 
feature  that  the  insured  is  entitled  at  the  expiration  of  the  policy  to 
•  take  out  another  contract  without  medical  examination  at  the  rate 
which  he  would  be  charged  at  his  attained  age  if  he  were  accepted  as  a 
new  applicant.  Convertible  term  policies  provide  that  the  insured 
may  at  any  time  during  the  life  of  the  contract,  or  at  its  expiration, 
exchange  his  policy  for  one  of  the  other  standard  types  of  insurance 
contract,  either  paying  the  premium,  which  would  be  due  if  he  were 
taking  out  a  new  contract  at  the  time  of  conversion,  or  else  taking  the 
rate  which  would  have  been  appropriate  to  his  age  at  the  time  of  the 
original  application,  and  paying  the  back  premiums  with  interest. 

Whole  life  policies  provide  that  the  insurance  shall  extend  through¬ 
out  the  life  of  the  insured.  As  is  the  case  with  term  insurance,  various 
options  as  to  manner  of  payment  of  premiums  are  offered.  The  whole 
life  policy  with  level  annual  premium  is  the  most  popular  of  the 
standard  types  of  policy. 

Endowment  life  policies  provide  insurance  for  a  stipulated  term  of 
years,  most  often  twenty,  with  the  provision  that  in  case  the  insured 
survives  the  term  of  the  contract  the  insurance  is  due  at  once.  The 
pure  endowment,  a  rare  contract  in  its  simple  form,  provides  for  the 
payment  of  a  stipulated  sum  only  in  case  the  beneficiary  survives  a 
definite  period.  Life  annuities  provide  an  income  of  a  stipulated 
‘amount  throughout  the  life  of  the  beneficiary.  The  life  annuity  is 
really  a  series  of  pure  endowments  for  successive  periods.  Disability 
clauses  in  life  insurance  policies  provide  that  the  total  and  permanent 
disability  of  the  insured  shall  operate  either  to  terminate  liability  for 
further  payment  of  premiums,  or  to  mature  the  policy,  or  otherwise 
modify  the  terms  of  the  contract. 

Classification  according  to  method  of  payment  of  premiums.-— Single 
premium  insurance  is  paid  for  in  advance  in  a  single  payment.  Limited 
payment  life  contracts  provide  insurance  through  the  whole  life  but 
limit  the  premium-paying  period  to  a  term  of  years,  most  frequently 
twenty.  Level  premium  means  a  uniform  payment  throughout  the 


244 


RISK  AND  RISK-BEARING 


premium-paying  period.  The  most  frequent  types  are  the  level 
annual  premium  and  the  level  weekly  premium  collected  on  so-callec* 
industrial  policies.  A  natural  premium  is  a  premium  which  increases 
from  year  to  year  as  the  risk  increases.  This  type  of  premium  is 
found  only  in  renewable  term  policies. 

Classification  according  to  number  insured. — This  classification  is 
nearly  self-explanatory.  Individual  policies  cover  single  lives,  joint 
life  policies  mature  at  the  death  of  either  of  two  or  more  persons; 
group  policies  are  written  to  cover  a  large  number  of  persons  jointly. 
Group  policies  differ  from  joint  life  policies  in  that  they  are  not 
terminated  by  the  death  of  one  of  the  insured. 

The  classification  of  policies  according  to  type  of  insurer  is  given 
detailed  consideration  in  later  sections  of  the  chapter,  and  need  not 
be  analyzed  here. 

Classification  according  to  right  to  share  in  profits. — Participating 
policies  provide  for  the  return  to  the  insured  of  a  portion  of  his  premium 
in  the  event  that  earnings  of  the  insurer  justify  such  a  “dividend.” 
Customarily  the  premiums  on  such  policies  are  made  high  enough  so 
that  there  is  sure  to  be  some  dividend.  In  other  words,  the  dividend 
is  in  part  a  rebate  of  excess  premium  and  only  in  part  a  true  dividend 
or  distribution  of  profits.  Non-participating  policies,  as  the  name 
implies,  carry  no  claim  to  dividends.  “Participating  policies  at  non¬ 
participating  rates”  are  sold  by  a  few  companies.  These  are  partici¬ 
pating  policies  whose  premium  rates  carry  no  excess  “loading”  to 
provide  for  dividends,  hence  pay  only  relatively  small  amounts,  which 
are,  however,  true  dividends. 

Standard  policy  conditions. — The  conditions  embodied  in  standard 
types  of  policy  issued  by  the  majority  of  companies  have  been  sum¬ 
marized  by  one  writer  as  follows: 

1.  A  copy  of  the  application  is  attached  to  the  policy,  so  that  the 
insured  may  be  in  possession  of  the  complete  contract. 

2.  The  policy  contains  a  clause  setting  forth  that  it  shall  not  go  into 
force  and  effect  until  delivered  during  the  lifetime  and  good  health  of  the 
insured,  and  after  the  required  premium  has  actually  been  paid. 

3.  The  majority  of  companies  have  some  restrictions  relating  to  hazard¬ 
ous  occupations  during  the  first  or  first  two  policy  years. 

4.  Most  companies  have  some  restrictions  pertaining  to  military  and 
naval  service  during  war. 

5.  Practically  every  policy  contains  a  “suicide  clause”  in  one  or  another 
form. 

6.  The  policy  becomes  incontestable  after  one  or  two  years. 


LIFE  INSURANCE 


245 


7.  Provision  for  reinstatement  of  lapsed  policies  is  made  under  varying 
conditions. 

8.  Thirty-one  days’  grace  is  allowed  in  the  payment  of  every  premium 
after  the  first. 

9.  Participating  policies  contain  a  clause  stating  the  conditions  under 
which  dividends  will  be  paid. 

10.  Every  policy  embraces  a  table  specifically  indicating  the  surrender 
values  and  loans  available  in  each  year,  generally  beginning  with  the  third. 

11.  Most  companies  undertake  to  pay  claims  immediately  after  the 
receipt  of  proofs  of  death.1 

Most  of  these  clauses  require  no  explanation.  The  suicide  clause, 
formerly  very  sweeping  in  the  policies  issued  by  many  companies, 
now  generally  covers  only  the  first  policy  year.  Its  effect  is  to  free 
the  company  from  liability  in  the  event  that  the  insured  dies  by  his 
own  hand,  whether  sane  or  insane.  The  clauses  relating  to  military 
and  naval  service  usually  only  have  application  to  the  first  one  or  two 
years,  and  the  same  thing  is  still  more  generally  true  of  the  clauses 
which  restrict  the  insured  in  the  choice  of  occupations  and  in  his 
freedom  of  travel.2  In  all  these  causes,  the  intent  of  the  clause  is 
not  to  protect  the  company  from  liability  in  the  case  of  such  indi¬ 
viduals  as  would  normally  run  the  proscribed  hazards,  but  simply  to 
prevent  the  insurer’s  securing  an  undue  proportion  of  such  hazards 
on  account  of  a  tendency  of  people  to  take  out  insurance  after  they 
have  decided  to  commit  suicide,  to  engage  in  dangerous  occupations, 
or  to  travel  in  unhealthy  environments.3  The  “incontestable  clause” 
operates  to  debar  the  company  from  contesting  the  policy  after  a 
specified  time,  usually  one  year.  Exception  is  always  made  of  certain 
cases,  including  those  in  which  the  policy  is  invalidated  on  account 
of  non-payment  of  premium,  and  sometimes  such  other  items  as 
military  and  naval  service,  fraud  in  application,  etc.  In  case  the 
age  of  the  applicant  has  been  understated,  the  company’s  remedy  is 
not  cancellation  of  policy,  but  the  reduction  of  its  liability  to  such 
amount  as  the  premium  actually  paid  would  have  purchased  at  the 
correct  age  of  applicant.  Incontestable  clauses  never  waive  the 
application  of  this  remedy. 

1  Forbes  Lindsay,  The  Policy  Contract ,  pv  88.  (Pamphlet  published  by  the 
Pacific  Mutual  Life  Insurance  Company  of  California.) 

*  During  the  Great  War  most  insurance  companies  waived  restrictions  on 
military  and  naval  service,  so  far  as  the  services  of  their  own  countries  were  con¬ 
cerned. 

3  Cf.  discussion  of  adverse  selection,  p.  247. 


246 


RISK  AND  RISK-BEARING 


IV.  INSURANCE  COMPANY  ORGANIZATION 

Aside  from  the  fraternal  and  assessment  associations  described 
in  a  later  section,  life  insurance  organizations  fall  into  two  groups, 
known  respectively  as  stock  and  mutual  companies.  A  stock  company 
is  a  business  corporation  organized  to  carry  on  the  business  of  selling 
life  insurance.  In  internal  organization  such  a  corporation  differs 
little  from  corporations  organized  for  other  purposes.  Customarily, 
its  surplus  is  very  large  in  proportion  to  its  capital  stock,  for  the 
reason  that  in  its  early  history  an  insurance  company  requires  but 
little  capital,  and  the  need  for  additional  capital  as  its  business 
expands  can  be  met  by  accumulation  of  surplus  more  readily  than  is 
the  case  with  corporations  in  most  lines  of  business.  The  amount  of 
owned  capital  needed,  whether  in  the  form  of  stock  or  of  surplus, 
grows  relatively  smaller  with  the  growth  of  the  business,  for  the 
reason  that  very  little  of  the  capital  is  used  for  operating  purposes. 
The  insurance  company’s  services  are  paid  for  in  advance,  and  reserves 
owned  by  the  policyholders  are  carried  to  meet  the  demands  for  dis¬ 
bursements  which  arise  in  the  ordinary  course  of  business.  The 
function  of  the  owned  capital  is  to  serve  as  a  secondary  reserve 
against  abnormally  high  mortality  experience,  shrinkage  in  value  of 
investments,  or  other  contingencies  which  may  make  the  theoretically 
adequate  reserve  insufficient  to  protect  the  interests  of  policyholders. 
As  the  scale  of  business  grows  larger,  the  probability  of  considerable 
deviations  of  actual  from  anticipated  experience  grows  less;  hence 
the  expansion  of  capital  need  not  be  proportionate  to  the  growth  of 
the  business. 

Mutual  companies  have  no  stock.  Their  surplus  as  well  as  their 
reserves  belong  to  the  policyholders,  the  difference  being  that  the 
reserve  is  an  aggregate  of  individual  reserves,  each  of  a  definite  amount, 
while  the  surplus  is  a  single  fund,  the  joint  property  of  the  entire  group 
of  policyholders.  The  surplus  alone  performs  the  function  which  in 
stock  companies  is  performed  by  the  combined  capital  and  surplus. 
It  is  the  usual  practice  in  organizing  mutual  companies  to  start  with 
capital  stock  which  is  to  receive  a  fixed  rate  of  return,  if  earned,  and 
to  be  retired  by  repayment  to  the  stockholders  when  the  surplus 
becomes  sufficiently  large  to  render  such  retirement  safe.  Sometimes 
a  mutual  company  is  formed  by  the  retirement  of  capital  stock  of  a 
stock  company  which  was  formed  with  no  intention  of  mutualization. 

Mutual  companies  are  subject  to  the  control  of  policyholders, 
who  elect  the  trustees  and  officers.  Since  the  policyholders  are  always 


LIFE  INSURANCE 


247 


numerous  and  widely  scattered,  the  individual  policyholder,  as  a  rule, 
has  very  little  interest  in  the  results  of  elections,  and  the  tendency 
is  strong  for  control  once  lodged  in  a  certain  group  of  individuals  to 
remain  in  their  hands  so  long  as  they  care  to  exercise  it.  In  this 
respect,  however,  there  is  little  difference  between  the  situation  in  a 
mutual  company  and  that  in  a  stock  company  with  numerous  small 
stockholders. 

Stock  companies  are  far  more  numerous  than  mutual,  but  so  many 
of  the  larger  companies  are  of  the  mutual  type  that  the  volume  of 
business  done  by  the  mutuals  is  decidedly  in  excess  of  that  done  by  the 
stock  companies. 

V.  SELECTION  OF  RISKS 

One  of  the  most  important  problems  confronting  the  management 
of  any  insurance  company  is  the  proper  selection  of  risks  to  be  insured. 
This  is  particularly  true  in  life  insurance,  for  the  reason  that  the  com¬ 
pany  has  no  option  of  canceling  the  contract,  if  after  completion  it  is 
found  to  be  unfavorable  to  the  company’s  interests. 

In  a  consideration  of  the  methods  used  in  selecting  risks,  it  must 
be  emphasized  at  the  outset  that  it  is  not  the  purpose  of  selection  to 
secure  for  the  company  an  abnormally  favorable  experience.  Insur¬ 
ance  rates  are  based  on  statistical  experience  of  mortality,  and  if  the 
statistics  are  representative  of  the  group  to  be  insured  there  is  no 
occasion  for  precautions  to  obtain  a  more  favorable  result  than  that 
which  they  forecast.  The  necessity  for  selection  in  favor  of  the  insurer 
arises  from  the  necessity  of  preventing  selection  adverse  to  its  inter¬ 
ests,  for  there  is  a  constant  tendency  for  persons  who  believe  them¬ 
selves  to  be  poor  risks  to  present  themselves  as  applicants  for  insur¬ 
ance  in  greater  proportionate  numbers  than  do  good  risks.  It  has 
been  well  said  that  an  insurance  company  could  afford  to  insure  at 
uniform  rates  all  the  people  who  pass  a  certain  street  corner  on  a  given 
day,  provided  the  fact  of  such  intent  were  not  made  public,  but  if  the 
facts  were  known  a  stream  of  the  lame,  the  blind,  and  the  stricken 
would  be  sure  to  pass  that  corner.  In  order  to  prevent  discrimination 
against  themselves,  insurers  are  obliged  to  examine  every  application 
with  great  care,  and  the  necessity  for  this  scrutiny  adds  greatly  to 
the  expense  of  effecting  insurance. 

The  principal  methods  used  in  selecting  risks  are,  first,  discrimina¬ 
tion  against  certain  occupations;  second,  discrimination  against  resi¬ 
dents  of  certain  localities;  third,  discrimination  against  individuals 
who  attempt  to  procure  insurance  in  amounts  obviously  in  excess  of 


248 


RISK  AND  RISK-BEARING 


their  normal  needs — this  includes  cases  in  which  the  beneficiary  has 
no  insurable  interest  in  the  life  of  the  insured;  fourth,  inspection  and 
inquiry,  designed  to  aid  in  estimating  the  moral  hazard;  fifth,  medical 
examination;  and  sixth,  family  history.  In  the  better  companies, 
the  medical  examination  is  very  thoroughgoing,  and  frequently 
results  in  the  discovery  of  defects  previously  unknown  to  the  applicant. 

The  immediate  result  of  all  these  methods  of  selection  is  to  secure, 
not  the  homogeneous  group  of  risks  aimed  at,  but  the  introduction  of  a 
group  of  extra-favorable  risks.  At  the  earlier  and  middle  years  of 
life,  the  mortality  among  persons  who  have  recently  passed  an  exami¬ 
nation  for  life  insurance  is  about  half  the  normal  mortality  of  those 
whose  examination  was  five  or  more  years  previous.  The  “benefit 
of  selection”  decreases  rapidly  and  is  imperceptible  after  five  years. 

VI.  CALCULATION  OF  PREMIUMS 

The  following  discussion  of  the  method  by  which  life  insurance 
premiums  are  determined  makes  no  pretense  of  constituting  an  ade¬ 
quate  discussion  of  the  actuarial  problems  involved  in  the  science  of 
life  insurance.  Actuaries  have  developed  a  considerable  body  of 
mathematical  science,  making  possible  the  calculation  of  premiums 
with  a  minimum  of  labor.  The  formulas  given  in  this  chapter  are 
the  basic  formulas  from  which  the  actuarial  short  cuts  have  been 
developed,  and  are  useful  from  the  standpoint  of  justifying  the  rates 
rather  than  actually  calculating  them. 

The  calculation  of  an  appropriate  rate  for  an  insurance  policy 
requires  that  two  fundamental  assumptions  be  made.  First,  the 
assumption  that  among  the  group  of  insured  deaths  will  occur  with  a 
definite  frequency,  and  second,  that  the  funds  paid  into  the  insurance 
company  will  be  invested  to  yield  a  definite  rate  of  interest.  Both 
the  rate  of  mortality  and  the  interest  earnings  are  of  course  estimates, 
and  in  the  case  of  contracts  which  have  to  run  for  periods  varying 
from  less  than  a  year  to  perhaps  seventy-five  years,  there  is  obviously 
room  for  a  considerable  variance  of  opinion  in  making  the  estimate, 
and  consequently  a  necessity  for  conservatism  in  making  up  the  rates, 
so  as  to  insure  solvency  on  the  part  of  the  insurer  throughout  the  life 
of  the  contract. 

The  standard  device  for  calculating  the  rate  of  mortality  is  the 
mortality  table,  which  enumerates  the  anticipated  number  of  deaths 
from  year  to  year  in  a  hypothetical  group  of  lives.  The  table  most 
frequently  used  for  this  purpose  in  America,  the  so-called  American 
Experience  table,  runs  as  follows: 


LIFE  INSURANCE 


249 


AMERICAN  EXPERIENCE  TABLE  OF  MORTALITY 


Age 

Number 

Living 

Number 

Dying 

IO . 

100,000 

749 

11 . 

99,251 

746 

12 . 

98,505 

743 

13 . 

97,762 

740 

14 . 

97,022 

737 

15 . 

96,285 

735 

l6 . 

95,550 

732 

17 . 

94,818 

729 

l8 . 

94,089 

727 

19 . 

93,362 

725 

20 . 

92,637 

723 

21 . 

91,914 

722 

22 . 

91,192 

721 

23 . 

90,471 

720 

24 . 

89,751 

719 

25 . 

89,032 

718 

26 . 

88,314 

718 

27 . 

87,596 

718 

28 . 

86,878 

718 

29 . 

86, 160 

719 

30 . 

85,441 

720 

31 . 

84,721 

721 

32 . 

84 , oco 

723 

33 . 

83,277 

726 

34 . 

82,551 

729 

35 . 

81,822 

732 

36 . 

81 ,090 

737 

37 . 

80,353 

742 

38 . 

79,611 

749 

39 . 

78,862 

756 

40 . 

78,106 

765 

4i . 

77,341 

774 

42 . 

76,567 

785 

43 . 

75,782 

797 

44 . 

74,985 

812 

45 . 

74,173 

828 

46 . 

73,345 

848 

47 . 

72,497 

870 

48 . 

71,627 

896 

49 . 

7o,73i 

927 

5°-  •  . . 

69 , 804 

962 

5i . 

68,842 

1 ,001 

52 . 

67,841 

1,044 

Age 

Number 

Living 

Number 

Dying 

53 . 

66,797 

1,091 

54 . 

65 , 706 

1,143 

55 . 

64,563 

1,199 

56 . 

63,364 

1 , 260 

57 . 

62, 104 

1,325 

58 . 

60,779 

i,394 

59 . 

59,385 

1,468 

60 . 

57,917 

1,746 

61 . 

56,371 

1,628 

62 . 

54,743 

i,7i3 

63 . 

53,030 

1,800 

64 . 

51,230 

1,889 

65 . 

49,341 

1,980 

66 . 

47,36i 

2,070 

67 . 

45,291 

2,158 

68 . 

43,133 

2,243 

69 . 

40,890 

2,321 

70 . 

38,569 

2,39i 

7i . 

36,178 

2,448 

72 . 

33,730 

2,487 

73 . 

3i,243 

2,505 

74 . 

28,738 

2,501 

75 . 

26,237 

2,476 

76 . 

23,761 

2,43i 

77 . 

21,330 

2,369 

78 . 

18,961 

2,291 

79 . 

16,670 

2,196 

80 . 

14,474 

2,091 

81 . 

12,383 

1,964 

82 . 

10,419 

1,816 

83 . 

8,603 

1,648 

84 . 

6,955 

1,470 

85 . 

5,485 

1 , 292 

86 . 

4,i93 

1,114 

87 . 

3,079 

933 

88 . 

2 , 146 

744 

89 . 

1,402 

555 

90 . 

847 

385 

9i . 

462 

246 

92 . 

216 

137 

93 . 

79 

58 

94 . 

21 

18 

95 . 

3 

3 

This  table  was  prepared  in  the  late  sixties  from  the  experience  of 
two  life  insurance  companies,  and  is  not,  as  a  matter  of  fact,  an  accu¬ 
rate  table.  Typically  the  experience  of  life  insurance  companies 
shows  that  the  deaths  in  a  given  year  are  not  more  than  from  65  to 
75  per  cent  of  those  anticipated  according  to  the  table.  More 
accurate  tables  have  been  compiled  in  recent  years,  but  their  adoption 


250 


RISK  AND  RISK-BEARING 


is  retarded  by  two  considerations.  In  the  first  place,  a  tremendous 
amount  of  expense  would  be  involved  in  changing  from  one  table  to 
another.  In  the  second  place,  since  the  error  consists  of  an  over¬ 
statement  of  the  mortality,  its  effect  is  to  give  the  insurer  a  margin 
of  safety,  so  that  there  is  little  inducement  for  any  company  to  be  the 
first  to  break  away  from  the  established  practice.  An  overstatement 
of  the  mortality  by  30  or  40  per  cent  does  not  necessarily  mean  that 
the  insured  is  charged  a  correspondingly  excessive  premium.  The 
premium  includes  not  only  a  mortality  charge  but  an  allowance  for 
expenses,  and  if  the  margin  of  safety  in  the  mortality  table  were 
removed  by  the  adoption  of  a  more  accurate  table,  the  allowance  for 
expenses  would  have  to  be  increased.  In  fact,  a  few  companies  now 
write  certain  policies  for  a  premium  equal  to  that  required  by  the 
theoretical  mortality  and  the  theoretical  interest  rate,  getting  their 
entire  expense  allowance  out  of  the  mortality  saving  and  the  surplus 
interest.  So  long  as  competition  is  active,  the  question  whether  the 
mortality  table  is  a  high  or  a  low  table  presumably  does  not  have 
very  much  bearing  on  the  rates  that  will  be  charged.  It  does  have 
a  very  definite  bearing,  however,  on  the  relative  rates  charged  for 
insurance  at  various  ages  and  for  this  reason  the  continued  use  of  a 
table  which  is  now  obsolete  and  probably  never  was  accurate  offers 
ground  of  criticism. 

Interest  rate. — The  other  fundamental  assumption  of  actuarial 
science  is  the  assumption  of  a  rate  of  interest  to  be  earned  on  the 
funds  which  are  being  accumulated  during  the  life  of  the  insured. 
The  rates  most  frequently  used  at  the  present  time  for  this  purpose  are 
3  and  3J  per  cent.  Judged  by  the  rates  which  have  prevailed  in  the 
investment  market  during  the  last  few  years,  these  rates  seem  very 
low.  It  must  not  be  forgotten,  however,  that  the  reserve  on  a  given 
policy  may  remain  in  the  company’s  hands  for  half  or  three-quarters 
of  a  century,  and  the  company  must  guarantee  its  rates  to  the  policy¬ 
holder  for  a  corresponding  period.  When  the  states  first  began  estab¬ 
lishing  legal  tests  for  solvency  of  insurance  companies  some  sixty-five 
years  ago,  the  rates  used  were  nearly  always  either  4  or  4!  per  cent. 
These  rates  were  considered  conservative,  and  they  were  in  fact  well 
below  the  actual  earnings  of  well-managed  companies.  For  forty 
years,  however,  the  trend  of  interest  rates  was  downward,  and  the 
states  have  twice  had  to  change  the  rate  to  a  lower  one.  Therefore, 
despite  the  high  rates  to  be  obtained  on  safe  securities  during  recent 
years,  it  does  not  seem  unlikely  that  before  the  maturity  of  contracts 


LIFE  INSURANCE 


251 


now  open,  3  per  cent  will  once  more  seem  a  fair  return  on  such  high- 
grade  security  as  that  offered  by  the  policies  of  strong  life  insurance 
companies.1 

Before  examining  the  methods  used  in  calculating  premiums, 
several  terms  must  be  defined.  The  net  premium  is  the  amount  which 
the  insurance  company  must  charge,  assuming  a  given  mortality 
table  and  interest  rate,  in  order  to  meet  the  claims  of  holders  of 
maturing  policies,  without  allowance  for  expenses  or  profit  to  the 
insurer.  The  loading  is  the  amount  added  to  the  net  premium  to 
provide  for  these  elements.  The  gross  premium  is  the  actual  premium 
charged,  being  the  sum  of  the  net  premium  and  the  loading.  The 
mortality  charge  is  that  portion  of  a  premium  which  is  required  to  meet 
death  claims  during  the  year  in  which  the  premium  is  collected.  The 
reserve  is  the  accumulated  fund  resulting  from  the  excess  of  net 
premiums  over  mortality  charges,  together  with  interest  accumulations 
on  the  reserve  itself.  The  surplus  is  the  fund  of  accumulated  profits 
of  the  insurer.  It  arises  from  four,  principal  sources:  deficiency  of 
mortality  below  that  anticipated  in  accordance  with  the  table; 
excess  of  interest  earnings  on  the  reserve  over  the  rate  assumed  in 
figuring  the  premium;  excess  of  loading  over  actual  expenses  incurred; 
and  interest  on  the  surplus  itself  (in  the  case  of  a  stock  company  on  the 
capital  also). 

The  simplest  type  of  rate-making  problem  is  presented  by  the 
annual  renewable  term  policy.  To  simplify  it  still  farther,  we  will, 
for  the  present,  disregard  expense  loading  and  confine  attention  to 
the  calculation  of  the  net  premium. 

‘  Let  us  assume  then  that  we  wish  to  insure  for  $1,000  each  for  one 
year  a  group  of  men  of  normal  health  of  age  thirty-five.  Our  first 
problem  is  to  determine  the  risk.  The  American  Experience  Table 
of  Mortality  shows  that  of  81,822  men  living  at  age  thirty-five,  732 


will  die  within  one  year.  The  risk,  therefore  is, 


732 


and  if  the 


81,822, 

premiums  were  paid  at  the  same  time  that  the  policy  falls  due,  the 

net  premium  charge  would  be  ,  or  $8.9  5.  However,  insur- 

$81,822 

ance  premiums  are  paid  at  the  beginning  of  the  year  and  death  losses 
are  paid  after  the  deaths  occur.  An  accurate  calculation,  therefore, 
must  take  account  of  interest  on  the  premiums  from  the  time  they  are 


1  Cf.  Zartman,  Life  Insurance  Investments ,  pp.  55-60.  (Henry  Holt  &  Co., 
1906.) 


252 


RISK  AND  RISK-BEARING 


paid  until  the  average  time  that  the  death  losses  occur.  This  is  han¬ 
dled  in  practice  by  the  simple  assumption  that  the  losses  are  all  paid  at 
the  end  of  the  year.  Such  an  assumption  is  of  course  inexact.  If  death 
losses  occurred  uniformly  during  the  year,  the  average  time  from  the 
payment  of  premiums  to  the  death  of  the  insured  would  be  six  months, 
and  the  average  time  till  the  payment  of  the  policy  would  be  somewhat 
greater,  say  seven  months.  Since  the  mortality  rate  increases  with 
advancing  age,  the  actual  tendency  is  for  more  than  a  proportionate 
number  of  deaths  to  occur  in  the  latter  part  of  each  insurance  year, 
hence  the  average  time  till  the  date  of  payment  is  still  further  length¬ 
ened.  It  is  however  considerably  less  than  the  full  year  assumed 
in  the  insurance  calculations,  and  to  that  extent  the  standard  method 
of  calculation  involves  an  injustice  to  the  insuring  company,  which 
must  be  offset  by  an  allowance  favorable  to  the  company  at  some  other 
point  in  the  calculations.  As  we  have  seen  previously,  the  mortality 
tables  overstate  the  actual  mortality;  this  circumstance  much  more 
than  offsets  the  advantage  which,  the  insured  gains  from  the  assump¬ 
tion  of  payment  at  the  end  of  the  policy  year. 

The  present  worth  at  3  per  cent  of  $1  due  one  year  hence  is 
$.970874.  Under  the  terms  of  the  contract,  an  insurance  company 
issuing  81,822  policies  may  expect  to  have  to  pay  732  losses,  which 
we  will  assume  to  be  of  $1,000  each.  The  present  worth  of  $732,000 
due  one  year  hence  may  be  expressed  as  $1,000  X  732  X  .970874, 
which  is  the  amount  the  company  must  collect  in  premiums  at  the 
beginning  of  the  year.  The  net  premium  on  one  $1,000  policy  is 
therefore 


$1,000X732  X. 970874 
81,822 


or  $8.69. 


Our  next  step  is  to  develop  the  net  single  premium  for  whole 
life  insurance.  This  is  the  amount  which  paid  in  at  once  to  the 
insurance  company  will  enable  it  to  pay  each  of  the  insured  the  face 
of  his  policy  at  the  time  of  death.  This  involves  simply  a  repetition 
of  the  preceding  calculation  for  each  successive  year  of  life  to  the  end 
of  the  mortality  table.  Out  of  a  group  of  81,822  persons  of  age  thirty- 
five,  the  table  shows  that  737  will  die  at  age  thirty-six.  To  provide 
for  losses  on  their  policies,  we  must  have  in  hand,  not  $737,000,  but 
an  amount  which,  if  kept  at  interest  for  two  years,  will  amount  to 
$737,000  or  $i,oooX737X.97o874a.  In  like  manner,  to  provide 
for  the  losses  of  the  third  year,  we  must  have  in  hand  $i,oooX742X 
.9708743,  and  to  provide  for  the  death  losses  of  the  ninety-fifth  year, 


LIFE  INSURANCE 


253 


when  the  last  three  survivors  are  expected  to  die,  we  will  need  $i,oooX 
3X.97087461.  The  sum  of  the  amounts  necessary  for  payments 
due  on  account  of  those  who  die  in  the  various  years  of  life  is  of 
course  the  amount  required  to  provide  for  all  the  death  claims,  and  this 
sum  divided  by  81,822  is  the  necessary  contribution  of  each  member  of 
the  group.  This  is  known  as  the  net  single  premium  for  a  whole  life 
policy  for  $1,000  at  age  thirty-five. 

Annual  renewable  term  policies  and  whole  life  policies  sold  for 
single  premiums  are  rare.  The  most  common  type  of  insurance  is  the 
whole  life  policy  with  level  annual  premium,  and  it  is  this  premium 
which  we  must  next  examine.  The  expression  for  this  premium,  using 
the  same  age,  interest  rate,  and  mortality  table  as  before,  is 

$1,000  (732X.97o874+737X.97o8742+  ....  3X. 97o8746t)  . 

81, 822+81, o9oX.97o874+8o, 353  X-97o8742+  ....  +3X.97087460 

This  formula  is  derived  as  follows:  The  numerator  represents  the 
sum  of  the  present  worths  of  the  amounts  to  be  paid  out  during  each 
year  of  life,  and  is  the  same  as  the  net  single  premium  calculated 
above,  except  that  it  has  not  been  divided  by  81,822.  In  other  words, 
it  is  the  net  single  premium  for  the  group,  not  for  the  individual  policy. 
The  denominator  represents  the  sum  of  the  present  worths  of  the 
amounts,  which  will  be  paid  in  to  the  insurance  company  if  each  of  the 
insured  pays  one  dollar  a  year  for  his  natural  life.  One  dollar  from 
each  of  the  insured  yields  $81,822,  which  is  paid  now;  $81,090  will 
be  paid  one  year  hence  by  the  survivors  at  that  time,  and  therefore 
must  be  discounted  at  3  per  cent;  $80,353  will  be  paid  in  two  years  and 
is  discounted  at  3  per  cent  compound  interest  for  the  two  years;  so 
we  proceed  to  the  sixty-first  term,  which  is  the  present  worth  of  $3, 
paid  by  the  three  survivors  sixty  years  hence.  Since  the  numerator 
of  our  fraction  represents  the  present  worth  of  the  series  of  sums  which 
the  insurance  company  has  to  pay  out,  and  the  denominator  repre¬ 
sents  the  present  worth  of  the  series  of  sums  which  the  company  would 
take  in  if  it  charged  each  policyholder  $1  a  year,  the  fraction,  as  a 
whole,  must  represent  the  number  of  dollars  a  year  which  each  of  the 
insured  must  pay  during  his  lifetime  in  order  that  the  company  may 
come  out  even  on  the  whole  transaction. 

If  this  formula  is  thoroughly  understood,  the  derivation  of  the 
premiums  for  the  other  usual  types  of  insurance  is  comparatively 
easy.  If,  for  instance,  we  desire  to  obtain  the  premium  for  a  twenty- 
payment  life  policy,  we  notice  that  the  sums  to  be  paid  out  by  the 


254 


RISK  AND  RISK-BEARING 


company  are  exactly  the  same  as  under  a  whole  life  policy,  but  that 
the  premium  receipts  stop  at  the  twentieth  payment,  nineteen  years 
hence.  Hence,  we  keep  our  numerator  unchanged,  but  cut  off  all 
but  the  first  twenty  terms  of  the  denominator.  If  a  twenty-year 
term  policy  is  in  question,  the  level  annual  premium  is  obtained  by 
taking  the  first  twenty  terms  of  both  the  numerator  and  the  denomi¬ 
nator,  the  first  twenty  terms  of  the  numerator  representing  the 
amounts  to  be  paid  out,  those  of  the  denominator  representing  the 
amounts  that  will  be  received  in  that  time  at  $i  a  year  from  each 
surviving  member  of  the  group.  For  a  twenty-year  endowment 
policy,  the  calculation  is  the  same  as  for  a  twenty-payment  life  policy, 
except  that  for  the  last  term  of  the  numerator  we  must  substitute 
“$i, 000X65, 706X  .97087420,”  the  numeral  65,706  representing  the 
total  number  who  survive  to  age  fifty-four.  Some  of  these  will  die 
during  that  year,  the  rest  will  draw  $1,000  each  at  the  end  of  the 
year;  for  purposes  of  calculating  the  premium  the  result  is  the  same 
as  though  all  died  during  the  year.  This  calculation  is  therefore 
exactly  the  same  as  the  calculation  for  a  whole  life  policy  would  be  if 
the  mortality  table  showed  that  all  survivors  died  at  age  fifty-four 
instead  of  age  ninety-five.  It  will  be  noticed  that  the  whole  life  policy 
is  the  same  thing  as  an  endowment  at  age  ninety-six,  and  is  also  the 
same  thing  for  purposes  of  figuring  the  premium  as  a  sixty-one-year 
term  policy  at  age  thirty-five. 

The  premium  for  single  payment  life  is  obtained  in  exactly  the 
same  way  as  the  premium  for  twenty-payment  life,  except  that  only 
the  first  term  of  the  denominator  is  retained,  instead  of  the  first  twenty 
terms,  giving  us  the  expression: 

t 

$1,000  (732 X. 970874+737 X.9708742  ....  3X.97Q^746t)  . 

81,822 

The  premium  for  a  whole  life  policy  is  much  larger  than  the 
premium  for  annual  renewable  term  insurance  at  the  same  age. 
In  other  words,  the  purchaser  of  a  whole  life  policy  pays  in  the  early 
years  considerably  more  for  his  insurance  than  it  costs  the  company 
to  furnish  it.  The  excess  premium  is  held  in  reserve  to  enable  the 
insurance  company  to  furnish  insurance  at  less  than  the  mortality 
charge  in  the  later  years  of  life. 

The  sum  total  of  these  excess  payments,  together  with  their 
accumulated  interest,  constitutes  what  is  known  as  the  reserve.  The 
reserve  is  not  the  property  of  the  insurance  company  but  is  of  the 


LIFE  INSURANCE 


255 


nature  of  a  trust  fund  held  by  the  insurance  company  as  an  advance 
payment  for  insurance  to  be  furnished  later.  It  should  be  noted, 
carefully,  however,  that  the  amount  in  the  reserve  does  not  depend 
on  the  actual  mortality  of  the  insured  group  nor  on  the  rate  of  interest 
actually  earned.  It  is  the  amount  which  would  accumulate  if  the 
mortality  ran  exactly  according  to  the  table  and  the  interest  earnings 
were  exactly  as  assumed.  Any  saving  or  gain  due  to  lowered  mortality 
or  higher  interest  earnings  goes  not  into  the  reserve  but  into  the 
surplus,  and  is  the  property  of  the  company. 

The  theory  underlying  the  popularity  of  all  types  of  level  premium 
insurance  is,  that  if  insurance  is  charged  for  at  the  current  cost  of 
furnishing  the  insurance,  the  cost  gets  prohibitively  high  in  the  later 
years  of  life.  It  will  be  seen,  however,  from  the  foregoing  analysis 
of  the  way  in  which  the, premium  is  calculated,  that  the  cost  of  insur¬ 
ance  in  the  later  years  of  life  is  just  as  great  on  the  level  premium  plan 
as  under  the  natural  premium  plan.  The  only  differences  are  that 
under  the  level  plan  the  individual  pays  a  part  of  the  cost  of  his 
insurance  many  years  in  advance  and  is  credited  with  the  interest  at 
about  the  savings  bank  rate  on  these  payments;  and  second,  that  under 
this  plan  those  who  die  in  the  early  years  of  life  get  no  added  return 
for  the  added  payment  they  have  made,  while  those  who  live  through 
to  an  advanced  age  get  the  benefit  of  a  lower  premium  on  account 
of  the  contributions  of  their  fellows.  Of  a  typical  group  insured  at 
age  thirty-five,  20  per  cent  die  within  twenty  years.  The  difference 
between  what  this  20  per  cent  pay  for  insurance  under  a  level  plan  and 
what  they  would  pay  under  the  natural  premium  plan  is  their  loss  and 
the  other  policyholders’  gain.  This  gain  brings  up  the  return  on 
their  advance  payments  for  the  80  per  cent  who  survive,  from  3  or  3J 
per  cent  to  about  5  per  cent.  In  other  words,  the  level  premium  plan 
offers  the  policy-buyer,  in  early  middle  life,  a  combination  of  two 
opportunities:  First,  to  buy  an  insurance  policy  at  what  is  presumably 
a  fair  rate  for  the  insurance,  and  second,  to  invest  the  difference 
between  the  cost  of  insurance  and  the  level  premium  in  a  security  which 
offers  a  20  per  cent  chance  of  loss  and  a  5  per  cent  rate  of  return,  if  the 
loss  does  not  occur.  Surely  such  a  contract  hardly  constitutes  an 
extremely  attractive  speculative  investment.  If  it  is  judged  favorably, 
it  must  be  on  account  of  its  insurance,  not  its  investment,  feature. 

What  has  just  been  said  in  disparagement  of  whole  life,  as  com¬ 
pared  with  renewable  term  insurance,  applies  with  much  more  force 
to  limited  payment  life  policies  and  with  the  greatest  force  to  endow- 


256 


RISK  AND  RISK-BEARING 


ment  policies.  In  these  higher-priced  policies,  the  proportion  of  the 
premium  which  pays  for  the  insurance  service  is  relatively  small  and 
the  remainder  is  an  investment  on  which  nothing  will  be  realized 
unless  one  lives  out  the  term  of  the  contract,  and  no  more  than  good 
interest  if  he  does. 

It  is  true  that  under  the  renewable  term  plan  the  cost  of  insurance 
becomes  relatively  very  high  after  about  age  fifty-five.  But,  quite 
apart  from  the  fact  that  many  men  no  longer  have  dependents  by  the 
time  they  reach  that  age,  it  must  be  remembered  that  the  amount 
of  insurance  needed  by  the  time  that  age  is  reached  is  comparatively 
small,  even  if  there  are  persons  totally  dependent  on  the  earnings  of 
the  insured.  At  age  fifty-five  the  average  man  has  no  more  than  ten 
years’  probable  earning  life,  and  even  though  those  be  years  of  high 
earnings,  the  capitalized  value  of  the  short  period  is  much  less  than 
the  loss  in  case  of  death  earlier  in  life.  Moreover,  if  the  money  saved 
by  buying  term  insurance,  rather  than  limited  payment  or  endow¬ 
ment  policies,  has  been  invested  in  safe  securities  the  savings  accumu¬ 
lations  have  operated  to  reduce  the  volume  of  insurance  needed  in 
the  later  years  of  life.  The  logical  plan,  therefore,  is  to  reduce  the 
amount  of  insurance  during  the  later  years  in  order  to  offset  the  effect 
of  the  rapidly  advancing  renewal  rate. 

It  will  be  argued  in  reply  that  man  will  not  save  except  under 
pressure,  and  that  the  endowment  or  limited  payment  policy  is  there¬ 
fore  the  better  purchase  because  it  stimulates  a  more  or  less  automatic 
type  of  saving.  There  are  undoubtedly  cases  where  this  has  been  true, 
and  the  argument  is  not  without  force,  though  it  can  hardly  be  argued 
that  enforced  saving  is  always  a  gain.  There  must  be  some  cases 
where  the  savings  are  carried  over  from  a  time  when  they  are  more 
needed  to  a  time  when  they  serve  a  less  important  want,  but  they  are 
probably  relatively  few.  It  is  undoubtedly  true  that  most  men  who 
buy  low-priced  policies  are  apt  to  spend,  rather  than  save,  the  money 
they  thus  cut  off  their  insurance  bill.  But  most  men  who  take  out 
high-priced  insurance  policies  do  not  keep  up  the  payments  on  them 
either. 

There  is  no  real  pressure  on  anyone  to  keep  up  premium  payments 
after  a  policy  has  been  in  force  long  enough  to  make  the  full  reserve 
available  as  a  surrender  value;  indeed  the  larger  the  surrender  value 
grows,  the  greater  becomes  the  incentive  to  take  advantage  of  it. 

The  most  serious  practical  objection  to  investment  insurance  is 
the  fact  that  the  saving  it  represents  is  nearly  always  made  at  the 


LIFE  INSURANCE 


257 


expense  of  needed  protection.  Most  men  in  moderate  circumstances 
carry  far  less  insurance  than  is  necessary  to  protect  their  families. 
They  cannot  afford  the  premium  payments  necessary  to  give  complete 
protection  if  in  order  to  secure  the  protection  they  must  also  make 
payments  to  accumulate  an  endowment  fund  or  to  pay  for  the  cost 
of  protection  at  the  advanced  years  of  life;  if  pure  protection  were 
readily  available  and  were  encouraged  as  a  sales  policy,  there  would 
probably  be  a  great  increase  in  the  amount  of  protection  carried. 

Loading. — It  remains  to  consider  the  procedure  by  which  the 
theoretical  premium  derived  from  the  mortality  and  compound  inter¬ 
est  tables  is  weighted  to  provide  for  the  expenses  connected  with  the 
operation  of  the  insurance  company,  the  dividends  paid  to  stockholders 
or  policyholders,  and  the  increase  of  surplus  which  is  necessary  if  the 
company  is  to  be  enabled  to  take  care  of  an  increasing  volume  of 
business  with  safety.  The  addition  to  the  net  premium  made  for 
these  purposes  is  called  the  loading. 

The  process  of  figuring  loading  is  less  scientific  than  that  employed 
in  figuring  net  premiums,  and  the  results  obtained  differ  greatly  from 
one  company  to  another.  The  difficulty  in  determining  proper  loading 
arises  from  the  fact  that  while  most  companies  write  a  wide  variety 
of  policies,  the  major  part  of  their  expenses  are  either  jointly  due  to 
the  whole  volume  of  business,  or  if  attributable  to  specific  policies 
cannot  be  assessed  to  them  accurately  in  advance.  Approximations 
must  be  made,  and  the  degree  of  accuracy  in  these  approximations, 
which  it  is  worth  while  to  aim  at,  is  a  matter  concerning  which  opin¬ 
ions  differ  widely. 

The  following  are  the  fundamental  principles  which  are  generally 
accepted  as  governing  the  proper  distribution  of  expense:  First,  all 
expense  directly  attributable  to  the  investment  operations  is  taken 
care  of  by  the  investment  department.  This  expense  appears  as  a 
reduction  in  the  percentage  earned  on  the  investments;  hence  does 
not  have  to  be  taken  account  of  in  the  loading.  Second,  expenses 
which  vary  with  the  amount  of  the  premium  (such  as  commissions) 
are  best  assessed  as  a  percentage  of  the  net  premium.  Third,  expenses 
which  vary  with  the  size  of  the  policy,  and  in  general  those  which  do 
not  fit  into  either  of  the  other  categories  are  best  taken  care  of  through 
a  charge  proportionate  to  the  face  of  the  policy.  General  adminis¬ 
trative  expenses  and  settlement  costs  are  examples  of  the  charge  most 
often  assessed  in  this  manner.  It  is  this  third  group  of  expenses 
which  are  handled  in  the  least  satisfactory  manner,  as  a  considerable 


258 


RISK  AND  RISK-BEARING 


proportion  of  the  expenditure  really  depend  on  the  number  of  separate 
policies  rather  than  on  their  size.  The  logical  method  of  assessing 
these  costs  would  be  a  flat  charge  of  so  much  per  policy,  but  such  a 
charge  is  never  used  in  practice,  presumably  because  it  would  make 
the  smaller  policies  disproportionately  expensive  and  thereby  create 
difficult  problems  for  the  sales  force. 

The  methods  usually  employed  are  the  following,  the  details  of 
application  showing,  as  already  noted,  great  variation:  ( a )  a  straight 
percentage  of  the  net  premium;  ( b )  a  percentage  varying  with  the 
type  of  policy;  (c)  a  flat  sum  plus  a  percentage  of  the  net  premium; 
(d)  a  percentage  of  the  net  premium  plus  the  same  percentage  of  the 
corresponding  net  premium  for  ordinary  life  policies.  The  last 
method  is  defended  on  the  ground  that  the  cost  of  the  insurance 
features  of  the  contract,  rather  than  the  cost  of  the  combined  insur¬ 
ance  and  investment  features,  should  be  given  considerable  weight, 
since  the  investment  fund  carries  its  own  expense  loading  separately. 
This  method  results  in  a  higher  loading  on  all  policies  issued  at 
advanced  ages,  and  also  on  the  cheaper  forms  of  policy,  such  as  term 
policies,  but  this  is  deemed  equitable  in  view  of  the  fact  that  these 
are  the  types  of  policy  on  which  the  gains  from  favorable  mortality 
experience  are  normally  least. 

Participating  policies  regularly  carry  an  excessive  loading,  intended 
to  make  certain  the  payment  of  dividends.  The  method  used  in 
determining  the  amount  of  this  excess  loading  is  of  little  importance 
to  the  policyholder,  provided  the  method  used  in  apportioning  divi¬ 
dends  is  consistent  with  it. 

VII.  DISBURSEMENT  OF  LIFE  INSURANCE  FUNDS 

The  funds  received  by  an  insurance  company  from  its  policy¬ 
holders  are  disbursed  in  five  principal  ways.  The  first  charge  against 
them  is  of  course  the  cost  of  doing  business.  A  second  principal  class 
of  expenditure  is  the  payment  of  matured  policies.  A  third  is  the 
payment  of  surrender  values.  A  fourth  is  the  making  of  loans  to 
policyholders,  and  a  fifth  is  the  payment  of  dividends  to  stockholders 
and  policyholders. 

Expense. — The  expense  item  needs  no  special  discussion.  It 
includes  commissions  on  new  business  and  on  renewals,  expense 
of  medical  examination  and  the  investigation  of  applications,  the 
investigation  of  claims  and  the  contesting  of  those  whose  character 
makes  contest  advisable,  the  control  of  investments,  and  the  general 


LIFE  INSURANCE 


259 


administrative  and  clerical  costs.  The  heaviest  costs  are  those 
involved  in  selling,  in  investigating  applications,  and  in  recording 
the  issuance  of  policies.  Usually,  this  initial  expense  amounts  to 
75  or  80  per  cent  of  the  first  year’s  premium. 

Settlement  of  claims. — The  disbursement  of  funds  in  payment  of 
matured  policies  is  not  an  expense  but  a  return  of  capital  to  its  owners. 
There  is  probably  no  large  class  of  claims,  with  the  exception  of 
requests  for  withdrawal  of  bank  deposits,  which  are  settled  with  so 
little  friction  as  the  settlements  made  under  life  insurance  policies. 
It  is  the  policy  of  reputable  companies  to  contest  claims  only  in  cases 
where  there  is  fairly  conclusive  evidence  that  the  company  has  no 
real  liability.  In  the  early  days  of  insurance,  some  companies  fol¬ 
lowed  the  policy  of  contesting  claims  on  technical  grounds,  though 
this  practice  was  probably  more  prevalent  in  fire  than  in  life  insurance. 
Such  contests  are  expensive,  partly  because  juries  are  apt  to  be  preju¬ 
diced  in  favor  of  claimants,  and  judges  interpret  the  contracts  as 
strictly  as  possible  against  the  companies,  partly  because  of  the 
adverse  advertising  which  an  insurance  company  gets  from  its  contests. 

Optional  settlements. — Most  insurance  policies  provide  for  an 
optional  settlement  in  the  form  either  of  a  cash  payment  in  full  or  of  an 
annuity  to  the  beneficiary.  The  instalment  plan  provides  simply  that 
the  insurance  company  shall  pay  the  amount  of  the  insurance  in,  say, 
twenty  instalments  to  the  beneficiary  or  the  beneficiary’s  estate. 
In  this  case  there  is  an  allowance  for  interest  which  substantially 
increases  the  sum  to  be  paid. 

The  life  annuity  plan  of  settlement  provides  a  payment  of  a  certain 
sum  per  annum  to  the  beneficiary  for  life.  The  amount  of  the  annual 
payment,  under  this  contract,  depends  upon  the  age  of  the  beneficiary 
at  the  time  the  contract  is  taken  out.1 

A  continuous  instalment  contract  is  a  combination  of  the  instalment 
and  annuity  plans,  providing  for  the  payment  of  the  insurance  in 
annual  instalments  over  the  life  of  the  beneficiary,  or  for  a  specified 
term  of  years,  whichever  is  the  greater. 

Under  all  these  instalment  contracts,  the  beneficiary  is  relieved  of 
the  problem  of  investing  the  proceeds  of  the  policy,  and  incidentally 
also  of  the  payment  of  taxes  upon  such  investments.  The  rate  of 
interest  allowed  is  not,  by  present  standards,  high,  but  the  fact  that 
the  rate  is  guaranteed  for  a  term  running  far  into  the  future,  the  high 
degree  of  safety,  and  the  relief  of  the  beneficiary  from  responsibility 

1  For  further  discussion  see  pp.  276-80. 


26o 


RISK  AND  RISK-BEARING 


go  far  to  compensate  for  the  moderate  interest  rate.  Except  in  the 
cases  where  the  proceeds  of  a  cash  settlement  could  advantageously 
be  used  to  pay  off  existing  indebtedness,  some  sort  of  annuity  or  instal¬ 
ment  settlement  is  more  likely  than  not  to  be  of  advantage. 

The  following  quotation  emphasizes,  but  does  not  exaggerate, 
the  advantages  of  the  annuity  as  a  method  of  settlement: 

There  are  two  modes  of  settlement  of  a  life  insurance  benefit  at  the 
death  of  the  insured.  The  first  is  to  pay  down  the  whole  sum  at  once;  and 
this  method  has  been  followed,  with  only  rare  exceptions,  since  life  insurance 
began.  The  second  mode  is  to  pay  an  annuity  to  the  beneficiary  for  a 
certain  period  or  for  life;  this  has  been  the  exception.  But  this  latter  plan 
received  impetus  through  legislation  in  New  York  State  in  1906,  which 
included  in  a  standard  form  of  policy  contract  a  privilege  by  which  the 
insured  during  his  life  might  elect  to  have  the  principal  sum  paid  in  periodical 
instalments  after  his  death.  Since  then  one  after  another  of  the  American 
companies  has  issued  policies  containing  on  their  face  specific  provision  for 
the  payment  of  the  benefits  in  monthly  instalments  of  selected  amounts  and 
for  selected  periods. 

Fire  insurance  on  a  merchandise  stock  is  for  the  purpose  of  providing 
funds  with  which  the  stock,  if  burned,  may  be  replaced  without  loss  to  the 
merchant.  In  this  case,  the  sum  to  make  replacement  is  required  to  be 
available  immediately  after  loss  by  fire  in  order  that  new  stock  may  be 
purchased  and  business  resumed.  But  human  life  is  different,  it  is  in  no 
sense  possible  of  replacement  except  by  in  some  manner  arranging  for  a 
continuance  of  its  income  or  productive  value  which  would  cease  at  death. 
And,  moreover,  the  capitalized  value  of  the  life  paid  in  one  sum  is  not 
needed  and  cannot  be  used  for  the  emergency  called  for  by  family  insurance, 
except  that  it  be  invested  to  produce  income. 

It  is  in  the  nature  of  things  that  humankind  should  be  possessed  of 
ungratified  wants  which  more  means  would  fill;  it  has  been  so  since  com¬ 
mencement  of  time;  without  this  human  trait  material  progress  would 
cease.  It  is  common  in  both  man  and  woman;  but  possession  of  means 
earned  by  one’s  self  checks  desires;  unearned  means  fosters  them,  hence 
because  man  has  more  commonly  been  the  earner  and  provider  and  woman 
the  dependent  and  recipient,  the  trait  is  more  pronounced  in  her.  With 
the  beneficiary  of  the  small  insurer  it  manifests  itself  in  wish  for  better 
quality  and  make  of  articles  of  dress — in  a  new  hat  instead  of  one  made 
over  on  last  year’s  frame;  in  small  articles  of  personal  adornment  which 
have  been  promised  since  long  ago  but  have  never  come.  Yes,  so  many 
things  are  needed;  it  seems  as  though  they  had  been  accumulating  since 
wedding  day.  And  so  they  have;  and  so  they  will  continue  co  do;  for  it 
is  the  rare  nature  of  wants  that  their  fulfilment  gives  birth  to  greater 


ones. 


LIFE  INSURANCE 


261 


Doubtless  some  beneficiaries  under  lump  sum  life  insurance  policies  are 
endowed  with  a  measure  of  mental  and  moral  poise  which  no  great  calamity 
could  overturn.  But  this  cannot  be  known  of  a  certainty  as  to  any  partic¬ 
ular  one  until  the  test  is  made.  This  one  may  possess  the  quality  of  self- 
denial  in  degree  that  would  safely  guard  against  use  of  the  fund  for  unneces¬ 
sary  self-expenditures;  but  this  is  only  another  way  of  describing  her  who 
has  a  good  and  charitable  heart,  for  charity  and  self-denial  go  hand  in  hand. 
Caution  would  prevent  bestowal  of  any  portion  of  her  insurance  money  in 
charity  on  strangers.  Would  it  help  if  the  supplicant  were  a  relative  ? 

All  have  poor  relations;  the  insured  may  not  have  been  able  to  help 
during  his  lifetime,  but  there  is  now  a  large  sum  of  money  in  bank.  It  is 
not  charity  that  is  asked,  merely  a  loan  is  wanted;  and  long  before  the 
money  is  needed  it  will  be  repaid,  if  all  goes  well.  Shall  it  be  refused  ? 
No.  Husband  would  give  it  if  he  were  alive;  he  often  said  he  would  be 
glad  to  help  if  he  could ;  but  he  never  had  so  much  money  in  bank  without 
immediate  use  for  it.  Nay,  this  excuse  would  not  be  required;  the  money 
would  be  “loaned”  in  any  event;  for  denial  would  be  impossible  to  this 
kind-hearted  woman  with  the  means  at  hand.  Nor  would  repeated  requests 
of  the  same  nature  be  denied  if  accompanied  by  valid  or  plausible  reasons. 

Thus  under  lump  sum  policies  have  thousands  of  men  unwittingly 
insured  their  lives  in  part  for  the  benefit  of  needy  relations  and  friends 
whom  during  lifetime  they  could  not  afford  to  assist.  For  unless  he  does 
help  in  the  support  of  poor  relations  and  friends  during  his  lifetime,  no  man 
intentionally  includes  provision  for  them  in  his  life  insurance.  If  he  does 
provide  for  them  during  life,  then  it  is  unfair  to  his  beneficiary  if  he  does 
not  include  account  of  them  in  his  insurance.  But  if  he  cannot  help  them 
while  living,  it  is  unlikely  that  he  can  afford  the  high  premium  payments 
necessary  to  provide  for  them  after  death. 

The  possession  of  a  sum  of  ready  money  renders  its  owner  liable  to 
become  the  object  of  designing  persons  seeking  dishonest  advantage  with 
plausible  schemes  dressed  up  as  sound  investments.  The  beneficiary  is 
inexperienced  in  investments.  Knowledge  of  this  is  not  lost  on  promoters, 
and  leads  to  her  being  sought  out  as  an  easy  mark  for  their  designs.  No 
sooner  does  the  fund  reach  her  hands  than  skilled  wits  are  placed  in  the 
balance  against  hers.  With  what  result  is  well  known;  a  woman  unso¬ 
phisticated  in  sharp  business  practices  is  attacked  by  a  swindler  at  a  time 
when  she  is  without  defense,  and  imposed  on  and  robbed. 

But  assuming  the  investment  to  be  a  good  one,  still  a  difficulty  and  a 
danger  remain.  Will  the  income  be  sufficient  to  meet  expenses?  If  not, 
then  a  part  of  the  security  must  be  disposed  of  from  time  to  time  to  obtain 
principal  to  eke  out  living  expenses.  But  this  may  not  be  necessary.  Will 
the  money  be  left  invested?  The  security  is  transferable,  and  therefore 
salable;  the  better  the  value,  the  lower  the  interest;  the  lower  the  interest, 
the  greater  the  temptation  to  sell  and  reinvest  in  something  paying  more; 


262 


RISK  AND  RISK-BEARING 


and  the  higher  the  interest  the  less  the  value,  and  the  more  danger  of  loss 
of  interest,  or  of  both  principal  and  interest.  It  may  be  borrowed  upon  any 
day.  It  is  an  object  of  taxation.  It  is  subject  to  attachment.  And 
finally,  no  matter  how  high  the  rate,  the  interest  income  from  the  invest¬ 
ment  will  be  equivalent  to  a  low  rate  on  the  whole  amount  received  from 
the  insurance  company,  because  it  is  unlikely  that  all  of  the  insurance 
money  will  be  invested. 

These  modes  of  paying  the  benefit  may  be  had  in  any  form  of  policy — 
Term,  Whole  Life,  Limited  Payment  Life  or  Endowment.  It  costs  nothing 
extra;  the  premium  charged  is  exactly  proportionate  to  that  for  a  policy 
providing  for  an  equivalent  single  sum  benefit.  The  company  acts  as 
trustee  and  pays  out  to  the  beneficiary  the  sums  provided,  in  amount  and 
in  time  approximating  the  manner  in  which  the  income  of  the  insured  was 
received  during  life.  At  the  death  of  the  insured  the  financial  result  is 
the  same  as  if  the  discounted  value  of  the  unpaid  instalment  benefits  pro¬ 
vided  for  became  automatically  invested  at  3^  per  cent  compound  interest ; 
and  future  payments  continue  to  earn  and  compound  at  the  interest  rate 
until  all  of  both  principal  and  compounded  interest  is  paid  as  provided. 
Thus,  for  example:  in  a  policy  providing  for  $50  per  month  for  forty  years 
the  discounted  value  of  the  future  benefits  to  be  paid  is  $13,089,  and  it  is 
on  this  sum  that  the  insurance  premium  is  charged;  but  the  total  sum 
guaranteed  to  be  paid  over  forty  years  is  $24,000,  or  $13,089  of  principal 
and  $10,911  of  accumulated  interest. 

A  life  insurance  benefit  left  in  this  rpanner  can  be  used  only  for  the 
purpose  intended:  namely,  for  the  necessities  of  life  and  to  keep  home 
together.  It  cannot  be  sold  or  borrowed  upon,  because  it  is  not  transferable. 
It  can  be  attached  for  debt  only  if  contracted  for  the  necessaries  of  life. 
It  is  free  from  taxation  and  charges  of  fees  of  any  kind  whatsoever;  and 
finally,  the  law  prohibits  the  company  from  discounting  and  paying  the 
amount  in  one  sum  to  the  beneficiary  upon  her  request  unless  the  insured 
so  consented  during  his  life.1 

The  continuous  instalment  is  particularly  advantageous  in  cases 
where  the  insured  desires  to  provide  an  income  for  a  widow  for  life 
and  for  children  for  the  period  of  their  minority.  The  life  annuity 
feature  insures  an  income  to  the  widow  throughout  her  life,  while 
the  “continuous”  feature  provides  that  in  case  of  her  early  death  the 
payments  will  be  continued  for  a  term  of  years  sufficient  to  bring  the 
youngest  child  to  the  age  of  self-support. 

Surrender  values  are  now  a  regular  feature  of  practically  all 
life  policies  written  by  legal  reserve  companies,  except  term  policies. 
During  the  early  history  of  life  insurance,  it  was  quite  commonly 

1  From  an  anonymous  pamphlet,  Luxuries  or  Necessities. 


LIFE  INSURANCE 


263 


true  that  a  policyholder  who  failed  to  keep  up  his  premium  payments 
forfeited  all  his  rights  under  the  policy.  Such  a  practice,  however, 
was  obviously  unfair  to  the  holders  of  the  higher-priced  policies,  such 
as  endowment  policies,  for  the  man  who  lapses  after  carrying  a  high 
premium  policy  for  a  number  of  years  has  paid  much  more  than  the 
man  who  has  been  carrying  whole  life  or  term  insurance,  and  has 
received  no  more  in  return.  The  issuance  of  policies  containing  a 
provision  for  surrender  value  began  in  the  late  fifties,  and  in  1861 
Massachussetts  passed  the  first  non-forfeiture  law.  Similar  laws 
have  since  been  enacted  by  most  states. 

The  provisions  regarding  surrender  relate,  first,  to  the  length  of 
time  a  policy  must  be  carried  before  any  surrender  value  accrues; 
second,  to  the  amount  of  such  surrender  value;  third,  to  the  manner 
in  which  it  shall  be  paid.  In  most  cases  there  is  no  surrender  value 
till  the  third  or  fourth  year,  though  some  grant  it  in  the  second  year. 
From  what  has  been  said  above  concerning  the  excessive  proportion 
of  the  expenses  which  attach  themselves  to  the  first  policy  year,  it  is 
obvious  that  a  company  cannot  afford  to  grant  liberal  surrender 
values  till  a  sufficient  number  of  premiums  have  been  paid  to  compen¬ 
sate  it  for  this  expense. 

From  the  third  year  to  a  later  date,  varying  from  the  fifth  to  the 
fifteenth  year,  the  surrender  value  consists  of  the  legal  reserve  minus 
a  surrender  charge  which  gradually  decreases  as  the  policy  grows 
older,  and  in  no  case,  with  most  companies,  exceeds  2J  per  cent  of 
the  face  of  the  policy.  The  tendency  both  of  legislation  and  of  com¬ 
petition  between  insurance  companies  has  been  to  increase  the  liber¬ 
ality  of  the  surrender  values,  and  the  popularity  of  these  provisions 
is  evidenced  by  the  fact  that  from  one-fourth  to  one-third  of  the 
policies  terminated  are  surrenders  and  lapses.1 

Three  methods  of  payment  of  the  surrender  value  are  generally 
provided:  cash  settlement,  extended  insurance,  and  paid-up  insurance. 
Under  the  extended  insurance  plan,  the  policy  continues  in  force  for  a 
limited  period;  under  the  paid-up  insurance  settlement,  the  face  of 
the  policy  is  reduced  and  the  policy  remains  in  force  throughout  the 
life  of  the  insured.  Under  both  the  extended  insurance  plan  and  the 
paid-up  insurance  plan,  the  amount  of  insurance  is  such  as  the  cash 
surrender  value  will  purchase  as  a  single  net  premium.  If  the  insured 

1  The  statement  is  perhaps  too  sweeping,  as  a  very  large  proportion  of  the 
lapses  occur  in  the  first  or  second  year,  before  the  liberality  of  the  surrender  pro¬ 
visions  is  a  factor. 


264 


RISK  AND  RISK-BEARING 


indicates  no  option,  but  simply  stops  paying  premiums,  the  extended 
insurance  plan  is  applied  automatically.  At  the  close  of  the  extended 
insurance  period,  the  company,  before  closing  the  account,  must 
obtain  evidence  that  the  insured  is  still  living.  As  the  beneficiaries 
of  lapsed  policies  are  frequently  ignorant  of  the  existence  of  the 
extended  insurance,  which  may  run  for  many  years,  there  is  often  no 
small  difficulty  in  determining  whether  liability  actually  exists. 

Another  method  of  handling  lapsed  policies  has  recently  been 
introduced — the  automatic  premium  loan.  Under  this  plan,  the 
cash  surrender  value  is  applied  as  a  series  of  loans  to  meet  successive 
premium  payments,  and  the  policy  is  kept  in  force  till  the  cash  value 
is  exhausted.  The  advantage  of  this  plan  over  the  extended  insurance 
plan,  to  which  it  is  very  similar  in  effect,  is  that  under  the  premium 
loan  plan  the  policy  does  not  technically  lapse,  so  that  the  insured 
retains  the  right  to  reinstate  himself  by  paying  the  back  premiums, 
with  interest,  without  medical  examination.  On  the  other  hand,  the 
policy  expires  somewhat  sooner  under  this  plan,  as  5  or  6  per  cent 
interest  is  charged  against  the  premium  loan,  while  the  reserve  is 
accumulating  interest  at  the  rate  of  only  3  or  3J  per  cent. 

Policy  loans. — While  the  making  of  loans  on  the  security  of  policies 
is  not  theoretically  a  method  of  disbursing  funds  except  for  temporary 
purposes,  in  practice  a  large  proportion  of  the  accumulated  reserve 
is  actually  returned  to  policyholders,  through  loans  which  stand  as 
permanent  obligations  of  the  policyholders  and  are  deducted  from  the 
face  of  the  policy  at  maturity.  From  the  standpoint  of  an  insurance 
company,  a  loan  made  to  a  policyholder  and  secured  by  his  policy, 
provides  an  investment  in  most  respects  ideal.  There  is  no  cost  for 
investigation  of  the  application,  or  for  collection,  and  there  is  no  risk, 
for  the  applicant  is  borrowing  only  his  own  funds,  and  can  never 
secure  a  loan  in  excess  of  the  surrender  value  of  his  contract.  More¬ 
over,  the  rate  of  interest  charged  on  policy  loans  is  higher  than  that 
obtainable  in  most  years  upon  safest  investments,  though  this  is  not 
necessarily  true  in  the  years  of  high  interest  rates  when  the  largest 
volume  of  policy  loans  are  made. 

From  the  standpoint  of  the  company,  there  are  two  objections  to 
policy  loans.  In  the  first  place,  the  loan  privilege  creates  some  risk 
of  embarrassment  through  an  excessive  number  of  demands  for  loans 
at  the  same  time.  With  the  present  almost  universal  acceptance  of 
the  principle  of  making  loans  on  demand  up  to  the  full  cash  surrender 
value  of  the  policy,  the  risk  of  a  run  on  the  reserves  of  insurance 


LIFE  INSURANCE 


265 


companies,  in  time  of  financial  crisis,  is  not  negligible.  Some  authori¬ 
ties  are  inclined  to  regard  this  as  a  serious  objection  to  the  extension 
of  the  loan  privilege,  though  no  trouble  has  yet  resulted  from  it. 
Upon  the  whole,  the  risk  seems  much  less  serious  in  the  case  of  insur¬ 
ance  companies  than  is  the  similar  risk  in  the  case  of  savings  banks, 
and  the  experience  of  the  latter  indicates  that  the  danger  is  not  suffi¬ 
cient  to  justify  the  abandonment  of  such  a  profitable  field  of  invest¬ 
ment. 

The  other  objection  to  policy  loans,  more  serious  from  the  stand¬ 
point  of  insurance  administration,  is  the  fact  that  the  issuance  of  policy 
loans  has  a  marked  influence  in  increasing  the  lapse  rate.  The  reasons 
for  this  tendency  will  be  made  clearer  by  an  examination  of  the 
advantages  and  disadvantages  of  the  policy  loan  from  the  standpoint 
of  the  policyholder. 

Policy  loans  are  usually  taken  out  under  one  of  two  conditions: 
either  the  insured  resorts  to  the  company  as  a  source  of  temporary 
accommodation  to  meet  some  special  need  or  else  he  secures  capital 
for  permanent  investment,  or  for  the  retirement  of  debts  elsewhere, 
by  contracting  a  loan  which  he  has  little  or  no  intention,  at  least  no 
prospect,  of  repaying. 

The  first  class  of  loans  are  sound  financial  operations.  If  an 
individual  is  going  to  borrow  the  money  somewhere  anyway,  the 
reserve  on  his  life  insurance  policy  offers  several  advantages.  The 
insured  can  secure  the  loan  on  demand  without  any  investigation  of 
his  credit  standing,  and  he  will  not  be  interrogated  as  to  the  purpose 
for  which  he  intends  to  use  the  money.  Moreover,  after  the  first 
six  months  he  can  pay  off  his  loan  at  any  time,  without  loss  of  interest, 
and  the  rate  charged  is  usually  lower  than  the  rate  he  would  pay  at 
his  bank. 

Comparatively  few  policy  loans,  however,  are  of  this  type.  It 
is  stated  in  fact  that  only  8  per  cent  of  policy  loans  are  ever  repaid 
before  the  maturity  of  the  policy.1  Most  students  of  the  question 
seem  to  agree  that  such  permanent  policy  loans  are  objectionable 
from  the  standpoint  of  the  real  interests  of  the  borrower.  The  follow¬ 
ing  statement  from  a  prominent  insurance  company  official  is  typical 
of  the  opinion  generally  expressed  on  this  question,  both  by  insurance 
company  officials  and  by  academic  students  of  insurance  theory. 

The  policyholder’s  privilege  of  borrowing  a  portion  of  his  reserves  on 
the  security  of  his  insurance  contract  was  a  development  of  competition, 

1  Riegel  and  Loman,  Principles  of  Insurance ,  p.  107. 


266 


RISK  AND  RISK-BEARING 


and  like  the  giving  of  surrender  values,  the  idea  grew  and  the  original 
privilege  was  extended  until  the  plan  became  permanently  fixed  upon  the 
business  by  being  made  a  requirement  of  the  law. 

As  originally  intended,  this  privilege  would  have  been  a  great  service  to 
the  policyholder  and  to  the  companies  as  an  attractive  feature  or  induce¬ 
ment  to  insure,  but  as  in  the  case  of  surrender  values,  the  loan  privilege  has 
been  carried  to  extremes,  the  general  practice  now  being  to  loan,  as  well  as 
to  pay  as  a  cash  value,  the  full  reserve  upon  a  policy  after  the  tenth  year  of 
insurance. 

The  primary  purpose  of  this  law,  which  fastens  a  banking  function  upon 
life  insurance,  was  to  enable  the  policyholder  to  have  the  use  of  his  reserves 
in  time  of  financial  stress.  It  was  believed  that  this  would  be  of  great 
value  in  preventing  lapses  by  permitting  the  insured  to  apply  his  reserves 
to  the  payment  of  premiums  when  short  of  cash,  and  that  the  plan  in 
general  would  prove  an  attractive  one  as  an  inducement  to  the  taking  of 
insurance. 

These  advantages  are  freely  conceded,  but  experience  has  demonstrated 
that  they  have  been  largely  neutralized  by  the  disadvantages  and  the 
abuses  which  have  resulted  from  the  expansion  of  this  loan  privilege.  These 
loans  operate  directly  against  the  beneficiary  by  reducing  the  protection, 
for  only  a  small  per  cent  of  the  loans  are  repaid  by  the  borrowers  and  the 
rest  must  be  deducted  from  the  claims  at  death  or  from  surrender  values. 
They  also  encourage  lapsing  by  the  additional  burden  placed  upon  the 
policyholder.  Many  borrowers,  finding  their  protection  reduced,  their 
premiums  remaining  the  same  and  an  annual  interest  charge  to  pay,  become 
discouraged  and  lapse  or  abandon  their  policies.  An  injustice  is  also  done 
the  remaining  policyholders  by  the  low  withdrawal  charge  and  the  possible 
danger  of  a  “run”  on  reserves  in  time  of  panic.  Broadly  speaking,  the 
policy  loan  privilege  discourages  saving  and  encourages  spending.  • 


Ratio  of  Loans 

Year  to  Reserves 

(Per  Cent) 

1890 .  2.97 

1895 .  3- 62 

1900 .  6.13 

1905 .  9-83 

I9IO .  15.35 

1915 .  17-86 


Those  who  borrow  on  their  policies  are  not  satisfied  with  small  amounts. 
They  are  tempted  to  withdraw  all  the  money  they  can  get,  and  having 
gotten  it,  they  are  tempted  to  spend  it  for  pleasure  or  to  risk  it  in  busmess 
or  speculative  ventures.  The  result  is  that  a  temporary  loan  develops 
into  a  permanent  obligation,  and  the  idea  of  repaying  it  is  abandoned 
Consequently  when  death  comes  the  widow  finds  that  her  life  insurance 


LIFE  INSURANCE  267 

has  been  materially  reduced  and  then  bitter  disappointment  and  some¬ 
times  misery  and  hardship  follow. 

It  is  not  surprising,  therefore,  that  the  practice  of  borrowing  on  policies 
has  come  to  be  known  as  borrowing  from  the  widow  and  orphan.  No  con¬ 
cession  ever  granted  to  policyholders  has  operated  so  greatly  to  the  dis¬ 
advantage  of  beneficiaries. 

One  class  of  loans — those  taken  out  on  policies  issued  for  the  protection 
of  business  ventures  or  for  purely  commercial  purposes — are  justifiable; 
they  are  serving  a  purpose  for  which  the  contract  was  entered  into.  But 
one  cannot  view  with  equanimity  the  taking  of  loans  on  policies  issued  for 
family  protection,  and  unfortunately  the  greater  number  of  loans  are  taken 
on  this  class  of  policies.1 

The  case  presented  against  the  policy  loan  is  forceful,  but  in  the 
author’s  opinion  not  convincing.  Let  us  examine  it  more  closely. 
In  the  first  place,  the  characterization  of  insurance  borrowing  as 
borrowing  from  the  widow  and  the  orphan,  which  is  a  standard  point 
in  the  case  against  policy  loans,  carries  with  it  an  implication  that 
borrowing  from  some  other  source  would  not  have  the  same  effect 
on  the  financial  status  of  the  widow  and  the  orphan.  It  is  obvious 
that  if  the  policyholder  borrows  from  some  other  source,  and  the  debt 
remains  unpaid  at  the  time  of  his  death,  it  will  operate  to  reduce  his 
estate  just  as  the  policy  loan  operates  to  reduce  the  face  of  his  policy. 
Assuming  that  the  beneficiaries  are  the  heirs,  the  only  case  where  they 
benefit  from  placing  the  loan  somewhere  else,  rather  than  with  the 
insurance  company,  is  the  case  where  the  widow  and  the  orphan 
desire  to  evade  the  payment  of  the  debt,  and  the  estate,  aside  from 
insurance,  is  not  large  enough  to  cover  it.  The  proceeds  of  insurance 
policies,  so  long  as  they  are  kept  intact,  are  in  most  states  exempt 
from  the  claims  of  all  creditors  except  the  insurance  company.  Hence, 
whoever  desires  to  borrow  in  such  a  way  that  his  heirs  may  be  able 
to  evade  the  payment  should  avoid  the  policy  loan.  Such  cases, 
however,  are  not  particularly  frequent,  and  ought  not  to  work  a 
condemnation  of  the  loan  privilege.  The  real  test  of  the  desirability 
of  contracting  a  loan  is  not  the  source  from  which  the  funds  are 
obtained  but  the  purposes  for  which  they  are  used.  If  the  money 
is  used  to  invest  wisely  in  a  home,  in  the  reduction  of  existing  indebted¬ 
ness,  or  for  safe  investment  elsewhere  at  a  higher  rate  of  return  than 
the  interest  charged  by  the  n  urance  company,  there  is  no  reason 
why  the  reserve  should  not  be  borrowed. 

1  Adapted  by  permission  from  J.  B.  Lunger,  “The  Problem  of  Cash  Surrender 
and  Loan  Values,”  Annals  of  the  American  Academy  of  Political  and  Social  Science , 
LXX  (March,  1917),  54-58. 


268 


RISK  AND  RISK-BEARING 


The  real  objection  to  policy  loans,  aside  from  an  ancient  objection 
to  all  borrowing,  which  seems  to  be  nearly  obsolete  except  as  it  appears 
in  discussions  of  this  particular  question,  lies  in  the  fact  that  such  loans 
are  expensive.  The  money  which  the  policyholder  borrows  from  the 
company  at  5  or  6  per  cent  is  the  same  money  which  he  is  loaning  to 
the  company  at  3  or  3!  per  cent.  To  make  the  case  concrete,  let  us 
examine  the  case  of  an  individual  who  is  carrying  a  whole  life  policy, 
premium  $15.63,  on  which  he  has  made  twenty  payments.  His 
loan  value  is  $230.50.  If  he  is  to  borrow  that  amount  of  money  at 
all,  he  probably  cannot  do  better  than  to  borrow  it  from  the  insurance 
company.  If  he  does  so,  however,  and  pays  6  per  cent  interest,  he 
begins  at  once  to  pay  $29.46  per  annum  for  $769.50  insurance.  If 
he  is  still  a  good  insurable  risk,  it  will  pay  him  better  to  let  his  policy 
lapse,  take  the  cash  surrender  value,  and  take  out  a  new  whole  life 
policy  for  $1,000  at  a  premium,  of  say,  $30.05,  thus  gaining  $230.50 
additional  protection  for  59  cents  additional  annual  cost.1  A  recog¬ 
nition  of  the  relatively  expensive  character  of  the  protection  afforded 
by  policies  on  which  the  reserves  have  been  borrowed  must  be  a 
fundamental  reason  for  the  high  lapse  rate  among  borrowers. 

The  borrowing  transaction  does  not,  however,  create  the  unfavor¬ 
able  financial  situation  in  which  the  borrower  finds  himself.  It  merely 
calls  attention  to  it.  If  the  policyholder  in  our  illustration  does  not 
borrow  on  his  policy  at  all,  but  merely  keeps  it  in  force,  he  still  pays, 
not  $15.63  for  $1,000  insurance,  as  he  doubtless  believes,  but  $15.63 

1  The  rates  used  in  the  illustration  are  those  charged  by  a  well-known  company. 
A  similar  calculation  for  the  tenth  year  of  the  life  of  the  same  policy  shows  a  gain 
of  $98  in  protection  and  an  actual  reduction  of  93  cents  in  annual  cost  from  lapse 
and  reinsurance  as  compared  with  borrowing  the  reserve  at  6  per  cent.  Like 
calculations  using  the  rates  of  three  other  companies  show  the  following  results: 
Lapse  and  reinsurance  at  the  end  of  ten  years,  as  compared  with  permanent  bor¬ 
rowing  of  the  reserve,  results  in  a  reduction  of  annual  cost  of  96  cents  in  company  A, 
74  cents  in  company  B,  and  $1.04  in  company  C,  with  a  gain  in  protection  of  $98 
in  each  case.  At  the  end  of  twenty  years,  lapse  and  reinsurance  give  an  added 
cost  of  80  cents  in  company  A,  97  cents  in  company  B,  and  $4.23  in  company  C, 
for  which  $230.50  additional  protection  is  obtained.  In  this  calculation,  reserves 
have  been  figured  on  the  basis  of  3  per  cent;  if  they  are  figured  at  3I  per  cent  the 
gain  from  lapse  and  reinsurance  is  slightly  increased.  If  policy  loans  are  figured 
at  5  per  cent,  the  gain  from  lapse  is  much  less,  but  in  most  cases  is  still  apparent. 
The  foregoing  calculations  are  all  for  non-participating  policies;  in  the  case  of 
participating  policies,  the  calculation  is  much  more  complicated  and  involves  a 
large  element  of  approximation.  On  account  of  the  practice  of  paying  increased 
dividends  on  older  policies,  it  is  probable  that  in  most  cases  permanent  borrowing 
on  participating  policies  is  cheaper  than  lapse  and  reinsurance. 


LIFE  INSURANCE 


269 


plus  the  income  he  could  secure  from  $230.50  for  $769.50  of  insurance. 
For  the  individual  who  has  become  uninsurable  since  he  took  out  his 
original  policy,  such  a  contract  may  be  very  favorable,  but  for  the 
good  risk  it  is  much  less  favorable  than  it  appears. 

The  reason  for  this  tendency  of  an  insurance  policy  to  become  more 
and  more  expensive,  so  far  as  its  real  insurance  features  are  concerned, 
is  primarily  the  fact  that  the  longer  one  carries  his  policy,  the  large 
the  fund  which  he  has  accumulated  and  on  which  he  is  receiving  only 
savings  bank  interest.  The  man  who  is  borrowing  at  6  per  cent, 
from  any  source,  cannot  afford  to  invest  at  3!  per  cent. 

All  this  fortifies  the  contention  of  a  previous  section,  that  renew¬ 
able  term  insurance,  first,  when  obtainable,  and  next  to  that  whole 
life  insurance,  are  the  most  economical  and  logical  types  of  insurance 
from  the  standpoint  of  the  policyholder,  except  in  those  cases  where 
the  mild  degree  of  compulsion  afforded  by  the  insurance  contract 
enables  a  policyholder  to  save  what  he  would  otherwise  squander. 

VIII.  SPECIAL  TYPES  OF  LIFE  INSURANCE 

Group  insurance. — One  of  the  newest  developments  in  life  insur¬ 
ance  is  the  group  policy.  This  is  a  term  policy  written  on  the  lives 
of  a  large  number  of  individuals,  employees  of  a  single  firm,  and  paid 
for  by  the  employer.  The  typical  provisions  of  such  a  contract  are: 

1.  No  medical  examination  is  required,  except  when  the  number  of 
employees  is  small.  Reliance  is  placed  on  the  operation  of  the  law  of 
large  numbers  to  secure  a  normal  mortality  experience,  while  the 
character  of  the  group  is  usually  such  as  to  protect  the  insurer  against 
the  adverse  selection,  which  would  be  likely  to  result  from  the  omission 
of  medical  selection  on  ordinary  life  policies.  A  group  of  from  fifty 
to  a  hundred  lives  is  considered  sufficient  to  insure  working  of  the 
law  of  averages. 

2.  The  policy  is  taken  out  by  the  employer;  the  premiums  are 
paid  by  him;  but  the  proceeds  are  payable  to  the  heirs  of  the  insured 
employees,  either  directly  or  through  the  employer. 

3.  Each  policy  is  written  as  the  result  of  a  special  investigation. 
The  rate  charged  depends  on  such  factors  as  the  age  distribution  of 
the  insured;1  the  proportion  of  women  employees,  the  standard  of 
living;  the  occupational  risk  of  injury  or  disease;  and  similar  factors. 

1  Not  simply  the  average  age.  Examination  of  the  mortality  table  will  show 
that  two  groups  of  the  same  average  age,  but  having  differing  proportions  of  persons 
of  very  advanced  and  early  age,  will  show  very  different  mortality  rates  during 
the  life  of  a  short  term  policy.  » 


270 


RISK  AND  RISK-BEARING 


4.  New  employees  ordinarily  come  under  the  protection  of  the 
policy  automatically,  under  specified  conditions,  the  premium  rate 
being  adjusted  from  month  to  month  as  the  hazard  changes. 

5.  Employees  severing  their  connection  with  the  organization 
automatically  lose  the  protection  of  the  policy,  unless  the  employer 
chooses  to  continue  paying  premiums  to  maintain  insurance  on  the 
lives  of  employees  during  temporary  lay-offs.  In  some  cases  the 
employee  is  given  the  privilege  of  retaining  protection  by  assuming 
responsibility  for  payment  of  premiums  at  a  rate  appropriate  for  his 
age.  Returns  of  unearned  premium,  without  surrender  charge,  are 
made  in  cases  where  the  liability  of  the  insuring  company  is  reduced 
through  the  separation  of  employees  from  the  pay-roll. 

6.  Several  methods  of  determining  the  amount  of  liability  are 
in  use.  The  following  alternatives  are  suggested  by  one  insurance 
company  which  has  been  a  leader  in  the  development  of  group  insur¬ 
ance: 

1.  The  same  amount  of  insurance  for  all  employees,  such  as  $500, 
given  either  immediately  on  employment  or  after  a  waiting  period,  such  as 
six  months  or  one  year. 

2.  An  amount  equal  to  the  annual  wage  of  an  employee  or  some  per¬ 
centage  thereof. 

3.  An  amount  to  be  based  on  length  of  employment,  such  as  an  initial 
amount  of  $500  after  one  year  of  employment  and  adding  thereto  $100  for 
each  additional  year  of  service  until  a  maximum  of  some  fixed  amount  has 
been  attained,  such  as  $1,000  or  $1,500.  Any  other  plan  or  formula  which 
meets  conditions  more  favorably  than  those  suggested,  may  be  adopted.1 

7.  Provision  is  frequently  made  that  the  policy  shall  mature 
immediately  as  to  any  employee  who  becomes  totally  and  permanently 
disabled.  In  such  cases  it  is  customary  to  provide  for  the  payment  of 
the  insurance  in  instalments. 

The  primary  purpose  of  group  insurance  is  to  increase  employees’ 
good  will  toward  the  organization  which  they  serve,  thereby  reducing 
labor  turnover  and  adding  to  the  efficiency  of  the  individual  laborers. 
It  is  believed  that  in  many  cases  money  expended  in  paying  premiums 
on  a  group  policy  will  buy  more  added  productive  effort  than  will  a 
similar  amount  of  money  spent  for  the  same  purpose  through  increased 
wages.  It  is  also  argued  that  an  insurance  policy  will  serve  as  an 
especially  attractive  feature  of  the  service  in  the  case  of  married 

1  From  an  analysis  of  group  insurance  published  by  the  Travelers’  Insurance 
Company. 


LIFE  INSURANCE 


271 


employees  and,  in  general,  among  the  steadier  class  of  workers  whose 
continuous  services  it  is  especially  important  to  retain. 

So  far  as  the  insurance  features  of  the  group  insurance  plan  are 
concerned,  the  device  seems  so  far  to  have  been  eminently  successful. 
The  elimination  of  medical  examination,  the  small  amount  of  work 
connected  with  the  issuance  and  recording  of  policies,  the  simplifica¬ 
tion  of  collections,  and  the  lowered  commissions  which  may  properly 
be  paid  to  agents  for  selling  insurance  on  the  wholesale  plan,  combine 
to  make  this  an  especially  economical  and  at  the  same  time  profitable 
type  of  insurance.  Whether  the  plan  has  been  equally  successful  as  a 
device  for  improving  the  relations  of  employers  and  employees  is 
uncertain.  The  question  is  at  best  a  difficult  one  to  answer  accurately, 
and  the  period  during  which  group  insurance  has  been  in  vogue  is  so 
short,  and  labor  conditions  have  been  <0  unstable  during  that  period, 
that  no  real  test  can  as  yet  be  said  to  have  occurred. 

Industrial  insurance. — Another  type  of  insurance  which  deserves 
particular  mention  is  the  so-called  industrial  policy.  This  is  a  policy 
for  a  small  amount,  usually  less  than  $500,  on  which  the  premiums 
are  collected  weekly  by  a  house-to-house  canvasser,  instead  of  being 
mailed  to  an  agent  of  the  company,  as  is  the  practice  with  most 
forms  of  life  insurance.  The  amount  of  the  premium,  instead  of  the 
face  of  the  policy,  is  stated  in  round  numbers,  the  most  frequent  unit 
being  five  or  ten  cents  per  week.  The  term  “industrial”  is  applied 
to  these  policies  not  because  they  have  any  connection  with  industry 
but  because  the  greater  number  of  such  policies  are  sold  to  wage¬ 
workers.  Such  policies  are  regularly  written  on  the  lives  of  children 
as  well  as  of  adults,  the  object  being  to  provide  for  the  expenses  of  last 
sickness  and  burial.  For  this  purpose  such  insurance  performs  a 
useful  service. 

The  chief  objection  to  the  industrial  policy  is  its  high  cost,  the 
premium  usually  working  out  about  double  the  cost  of  whole  life 
insurance  of  the  ordinary  type.  No  cash  surrender  or  loan  value  is 
usually  allowed,  until  the  policy  has  run  for  a  very  long  period,  but 
paid-up  insurance  for  a  portion  of  the  face  is  allowed  in  cases  where 
the  policy  has  been  carried  for  a  few  years. 

The  high  cost  of  this  type  of  insurance  is  due  primarily  to  the 
excessive  cost  of  collection.  Another  reason  is  found  in  the  high 
lapse  rate,  which  makes  the  selling  cost  greater  than  would  be  the 
case  if  the  policy  once  placed  did  not  so  frequently  have  to  be  replaced 
by  another  in  order  to  keep  the  volume  of  business  constant.  A  third 


272 


RISK  AND  RISK-BEARING 


reason  for  the  high  cost  is  found  in  the  mortality  rate,  which  is  con¬ 
siderably  higher  than  is  the  case  with  ordinary  policies,  partly  on 
account  of  a  somewhat  higher  normal  death-rate  in  the  class  of  the 
population  who  make  up  the  bulk  of  the  policyholders,  and  partly 
on  account  of  the  lack  of  medical  examination.  Formerly  it  was  the 
practice  to  require  a  very  superficial  examination  by  a  physician,  but 
the  present  practice,  so  far  as  policies  of  less  than  $500  are  concerned, 
is  to  place  on  the  agent  the  responsibility  of  inspecting  the  candidate 
and  certifying  to  his  apparent  good  health.  Naturally,  this  method 
leaves  opportunity  for  rather  more  adverse  selection  than  is  possible 
where  regular  medical  examination  is  required,  though  the  difference 
is  less  than  might  readily  be  anticipated. 

Fraternal  insurance. — One  of  the  most  interesting  developments 
in  American  life  insurance  is  the  insurance  written  by  the  various  fra¬ 
ternal  orders,  beginning  with  the  organization  of  the  Ancient  Order  of 
United  Workmen,  in  1868.  The  original  idea  underlying  the  work  of 
these  companies  was  to  make  insurance  incidental  to  the  operation 
of  a  system  organized  primarily  for  the  purposes  of  mutual  assistance 
and  social  intercourse  within  a  selected  circle.  Insurance  of  this 
sort  characterized  the  medieval  guilds,  and  has  frequently  been 
written  as  incidental  to  organizations  formed  for  other  puiposes. 
In  the  case  of  the  fraternal  orders,  however,  the  insurance  feature  has 
proved  so  popular  as  to  overshadow  the  social  side  of  many  of  the 
organizations,  so  that  they  have  become  insurance  societies  with  a 
fraternal  feature  rather  than  fraternal  societies  with  an  insurance 
feature.  This  development  indirectly  led,  in  many  cases,  to  the  under¬ 
mining  of  the  insurance  feature  itself.  The  original  plan  was  a  straight 
assessment  plan,  each  member  paying  his  share  of  the  sum  due  to  the 
relatives  of  the  deceased.  Such  a  system  can  be  worked  successfully 
with  a  cost  very  much  lower  than  the  rates  charged  by  legal  reserve 
companies  for  “old  line”  insurance,  provided  the  membership  remains 
from  year  to  year  of  the  same  fairly  low  average  age.  In  a  labor 
union,  for  example,  the  tendency  is  for  the  older  members  to  drop 
out  of  the  organization  and  be  replaced  from  year  to  year  by  young 
men,  so  that  the  average  age  and  the  average  mortality  remain 
unchanged.  Assessment  societies  among  the  employees  of  corpora¬ 
tions  have  operated  very  successfully,  the  tendency  being  here  also 
for  the  older  members  to  drop  out  of  employment,  so  that  the  mor¬ 
tality  is  the  relatively  low  mortality  of  people  who  are  able  to  stay  on 
the  pay-roll. 


LIFE  INSURANCE 


273 


In  the  fraternal  insurance  society,  on  the  other  hand,  there  is 
just  the  opposite  tendency.  The  older  the  member  gets,  the  less 
likely  he  is  to  drop  out.  As  a  result,  the  average  age  increases  and  the 
assessments  grow  heavier.  As  the  assessments  grow  heavier,  it 
becomes  more  difficult  to  secure  young  members,  the  younger  men 
finding  it  more  advantageous  to  go  into  newer  societies  with  a  lower 
assessment  rate.  As  soon  as  the  younger  members  stop  coming  in, 
the  death  of  the  organization,  so  far  as  its  insurance  features  are  con¬ 
cerned,  becomes  merely  a  matter  of  time.  As  each  member  dies,  a 
larger  assessment  on  the  remaining  members  is  necessary  until,  if 
the  plan  were  carried  through  to  the  end,  the  last  surviving  member 
would  have  to  pay  the  entire  face  of  the  policy  of  the  next  to  the  last 
member,  and  would  then  be  left  himself  without  insurance.  Long 
before  this  contingency  arises,  however,  assessment  orders  cease  to 
function. 

As  the  weakness  of  assessment  insurance  became  apparent  in  the 
eighties  and  early  nineties,  the  stronger  fraternal  orders  shifted  from  the 
straight  assessment  plan  to  the  graded  assessment,  a  plan  under  which 
the  assessment  varies  with  the  age  of  the  member  at  entrance.  Such 
a  plan  is  theoretically  workable,  but  in  practice  has  not  proved  much 
more  stable  than  the  original  flat  assessment,  for  the  reason  that  the 
assessments  have  not  been  large  enough  to  provide  adequate  reserves 
and  the  lack  of  reserves  has  made  it  necessary  to  increase  the  number 
of  assessments  as  the  orders  grow  older,  so  that  the  same  tendency 
for  younger  men  to  drop  out  and  older  men  to  stay  in  has  appeared. 

Since  about  1910,  the  weakness  of  the  ordinary  type  of  fraternal 
insurance  without  adequate  reserves  has  become  so  apparent  that 
there  has  been  a  general  movement  to  reorganize  the  fraternals  on  a 
“legal  reserve”  basis.  The  reorganization  has  involved  the  adoption 
by  the  fraternal  companies  of  the  fundamental  actuarial  principles, 
which  we  have  seen  above  applied  to  ordinary  commercial  insurance. 
A  fully  reorganized  fraternal  society  with  adequate  reserves  differs 
from  an  “old  line”  company  only  in  the  following  respects: 

First,  the  fraternal  companies  use  their  own  mortality  table, 
which  shows  a  somewhat  lower  mortality  and  is  probably  considerably 
more  accurate  than  that  used  by  the  old  line  companies. 

Second,  the  interest  allowance  is  figured  in  some  cases  at  4  per  cent. 

Third,  the  government  of  a  fraternal  order  is  much  more  demo¬ 
cratic  than  that  of  an  old  line  company,  even  though  the  latter  be 
mutual  in  character. 


274 


RISK  AND  RISK-BEARING 


A  considerable  proportion  of  the  members  take  some  part,  as  a 
rule,  in  shaping  the  policies  of  the  order.  From  the  local  unit,  the 
lodge,  delegates  are  sent  to  district,  state,  and  national  conventions, 
and  important  matters  of  policy  are  settled  directly  by  these  national 
conventions.  Fraternal  newspapers  do  much  to  create  an  effective 
public  opinion  among  the  members. 

Fourth,  the  expense  loading  in  the  premiums  is  very  low,  though 
not  as  low  as  in  a  few  of  the  old  line  companies.  The  actual  expenses 
of  the  fraternal  organization  are  almost  invariably  lower.  This  is 
partly  because,  in  line  with  democratic  precedent,  it  is  their  custom 
to  pay  relatively  small  salaries  to  their  officers,  and  partly  because 
the  fraternal  features  have  enabled  them  to  keep  their  selling  costs 
very  low,  a  large  part  of  their  publicity  being  secured  by  the  unpaid 
work  of  the  membership. 

In  the  early  history  of  the  fraternal  orders  there  were  no  paid  agents 
at  all,  but  more  recently  there  has  arisen  a  system  whereby  “deputies” 
are  paid  small  commissions  to  visit  the  local  lodges  and  put  on  cam¬ 
paigns  for  new  members.  Their  commissions,  however,  can  be  kept 
relatively  small  because,  whereas  the  agent  for  an  old  line  company 
has  to  find  his  own  prospects  and  close  his  own  sales,  the  fraternal 
deputy  operates  by  stirring  up  the  enthusiasm  of  the  members  and 
getting  them  to  do  much  of  the  work,  often  through  the  medium  of 
contests  between  neighboring  lodges,  or  between  picked  teams  in  the 
same  lodge. 

Fifth,  fraternal  insurance  certificates  carry,  as  a  rule,  no  cash 
surrender  value  and  no  loan  value. 

Sixth,  a  fraternal  insurance  certificate  is  not  a  contract  whereby 
the  order  promises  to  furnish  a  given  amount  of  insurance  for  a  stipu¬ 
lated  sum.  The  rates  are  always  subject  to  readjustment  by  action 
of  the  order,  and  the  amounts  payable  may  be  scaled  down  in  case  the 
order  is  unable  to  pay  the  full  amount.  Hence,  it  is  almost  impossible 
for  a  fraternal  order  to  become  technically  bankrupt.  Its  liabilities 
consist  only  of  its  matured  claims. 

Seventh,  the  beneficiary  has  no  legal  equity  in  a  contract  of  fra¬ 
ternal  insurance.  The  insured  can  change  the  beneficiary  at  any 
time,  although  as  a  rule  he  cannot  insure  in  favor  of  anyone  except  a 
dependent.  The  beneficiary  cannot  sell,  assign,  or  transfer  his  claim 
prior  to  the  death  of  the  insured,  because  he  has  no  legal  claim  to 
transfer,  nor  can  a  legal  equity  be  created  by  the  payment  of  premiums 
by  the  beneficiary. 


LIFE  INSURANCE 


275 


Fraternal  insurance  has  been  looked  upon  with  disfavor  by  most 
insurance  authorities  in  this  country,  chiefly  because  of  the  unsound 
actuarial  practices  with  which  it  has  so  frequently  been  associated. 
Nevertheless,  it  has  rendered  a  very  large  service  and  in  the  author’s 
opinion  is  worthy  of  a  better  rating  than  it  generally  gets.  Fraternal 
insurance  frequently  gets  a  “black  eye”  in  a  community,  because  of 
the  experience  of  members  Who  after  paying  insurance  for  twenty- 
five  or  thirty  years  and  becoming  too  old  to  secure  insurance  elsewhere, 
and  after  having  their  rates  raised  to  two  or  four  times  their  previous 
levels,  have  been  compelled  to  drop  their  policies.  What  is  overlooked 
in  these  cases  is  that  the  individuals  in  question  have  really  had  very 
cheap  protection  during  the  productive  period  of  their  lives,  and  if  they 
had  bought  the  insurance  as  term  insurance,  would  have  had  no  reason 
to  be  dissatisfied  with  their  bargains.  An  individual  who  gets  less 
than  he  bargained  for,  even  though  he  gets  as  much  as  he  paid  for,  is 
likely  to  express  discontent,  and  this  has  very  frequently  been  the 
situation  of  the  buyer  of  fraternal  insurance. 

The  history  of  the  fraternal  movement  in  this  country  can  never 
be  understood  if  it  is  viewed  merely  as  a  phase  of  the  history  of  life 
insurance.  It  is  a  part  of  the  great  social  democratic  movement  of  the 
late  nineteenth  century  of  which  the  Greenbackers,  the  Farmers 
Alliance,  the  Populist  party,  the  Free  Silver  movement,  the  United 
States  Grain  Growers,  Incorporated,  and  the  Non-Partisan  League 
are  more  conspicuous  manifestations.  The  fraternal  insurance 
enthusiast  of  the  eighties  and  nineties  was  an  apostle  of  freedom,  an 
advocate  of  the  rights  of  the  downtrodden  masses  against  the  greedy 
barons  of  Wall  Street.  The  enthusiasm  with  which  the  fraternal 
organizers  of  that  early  day  denounced  the  practices  of  the  old  line 
life  insurance  companies  amounted  almost  to  a  religious  faith.  In  the 
thought  of  these  apostles,  mortality  tables,  compound  interest  calcula¬ 
tions,  legal  reserves,  were  implements  of  darkness,  designed  to  separate 
the  trusting  citizen  from  his  money  and  place  it  at  the  disposal  of  the 
stock  manipulators  and  trust  magnates  of  the  East.  As  these  devices 
have  become  better  understood,  the  ardor  of  the  crusaders  for  their 
abolition  has  waned. 

In  any  evaluation  of  fraternal  insurance,  the  value  of  the  social 
features  must  not  be  overlooked.  As  noted  above,  fraternal  insurance 
has  been  sold  at  a  low  figure  because,  among  other  reasons,  the 
membership  as  individuals  have  carried  the  selling  costs.  This 
method  of  propagating  the  order  has  been  possible  only  because  the 


276 


RISK  AND  RISK-BEARING 


local  lodge  and,  to  a  less  extent,  the  larger  organization,  have  supplied 
a  real  social  need. 

In  every  small  community  in  the  country,  particularly  before  the 
advent  of  the  u  movie, ”  the  lodge  furnished  for  many  men  the  only 
excuse  for  staying  away  from  home.  The  ritual  of  the  order  has  often 
been  elaborate;  its  mastery  has  supplied  a  stimulating  exercise,  and 
the  opportunity  for  a  genuine  intellectual  triumph,  while  the  holding 
of  office  in  a  fraternal  order  has  furnished  an  opportunity  for  self- 
expression  and  an  object  of  ambition.  The  opportunity  to  wear  a 
resplendent  uniform,  to  appear  in  pomp  at  the  funeral  of  a  deceased 
brother,  the  winning  of  a  banner  for  surpassing  neighboring  lodges 
in  the  percentage  of  members  who  appear  in  procession  at  an  annual 
county  rally,  and  the  gaining  of  a  free  oyster  supper  by  beating  a 
rival  team  in  a  contest  in  securing  new  members — all  these  activities 
minister  to  genuine  human  wants,  and  because  this  is  true  the  orders 
have  been  able  to  propagate  themselves  without  expensive  selling 
organizations  and  to  furnish  insurance  at  a  minimum  cost. 

Life  annuities . — The  life  annuity  is  a  contract  designed  to  afford 
protection  against  the  hazard  of  the  individuals’  outliving  their  pro¬ 
ductive  capacity  and  becoming  a  burden  upon  the  community.  In 
many  respects  this  type  of  contract  is  exactly  the  reverse  of  the  insur¬ 
ance  contract.  Just  as  the  insurance  policy  insures  against  the 
financial  loss  due  to  premature  death,  the  annuity  policy  insures 
against  loss  due  to  prolongation  of  one’s  existence  beyond  his  earning 
period.  Insurance  policies  are  usually  paid  for  in  annual  instalments 
and  mature  in  one  lump  sum,  while  the  annuity  is  paid  for  in  a  lump 
sum  and  matures  in  a  series  of  annual  instalments.  No  medical 
examination  is  necessary  for  an  annuity,  as  the  only  adverse  selection, 
from  the  company's  standpoint,  is  that  arising  from  the  tendency 
of  persons  who  anticipate  long  life  to  purchase  annuities,  rather  than 
persons  who  know  themselves  to  be  in  doubtful  health.  If  it  were 
feasible,  it  would  be  logical  to  establish  medical  selection  to  eliminate 
the  abnormally  good  risks,  but  abnormalities  in  the  direction  of  a 
tendency  to  excessive  length  of  life  are  not  readily  identified.  The 
inaccuracy  of  the  mortality  table  to  which  reference  was  made  on 
page  249,  which  works  in  favor  of  the  company  in  ordinary  life  insur¬ 
ance,  would  work  against  it  in  writing  annuities,  hence  a  separate 
mortality  table  is  used  for  this  purpose. 

The  computation  of  annuity  premiums  is  similar  to  the  computa¬ 
tion  of  insurance  premiums  and  needs  no  extended  discussion.  The 


LIFE  INSURANCE 


277 


present  worth  of  the  sums  to  be  paid  to  the  various  members  of  a 
typical  group,  as  shown  by  the  mortality  table,  is  divided  by  the 
number  of  individuals  in  the  group,  to  get  the  net  single  premium  for 
the  policy,  and  loading  is  then  added  just  as  in  the  case  of  life  insur¬ 
ance.  The  uses  and  the  characteristic  features  of  life  annuities  are 
brought  out  with  such  fulness  in  the  following  account  that  little 
further  discussion  is  necessary: 

The  primary  function  of  the  life  annuity  is  to  insure  that  a  given  sum 
of  money  will  produce  a  life  income  larger  in  amount  than  could  be  safely 
secured  through  the  channels  of  ordinary  investment.  The  regular  life 
annuity  contract  is  a  promise  to  pay,  in  consideration  of  a  single  cash  sum, 
a  fixed  amount  periodically  during  the  lifetime  of  a  designated  person, 
called  the  annuitant.  Annuities  in  practice  are  paid  yearly,  half-yearly, 
quarterly  or  monthly. 

The  correct  method  of  computing  annuity  premiums  is  essentially  as 
follows:  The  mortality  table,  upon  which  the  computation  is  based,  con¬ 
sists  fundamentally  of  a  series  of  numbers,  showing  how  many  persons  out 
of  a  given  number  alive  at  the  youngest  age  in  the  table,  survive  to  each 
age  throughout  the  possible  range  of  life.  Given,  therefore,  a  large  group 
of  persons  all  of  the  same  age,  the  mortality  table  renders  it  possible  to 
forecast  how  many  of  the  group  will  be  alive  one  year  hence,  two  years 
hence,  three  years  hence,  and  so  on  until  all  of  the  members  of  the  group 
have  passed  away.  If,  therefore,  a  promise  should  be  made  to  pay  a  yearly 
annuity  of  a  dollar  to  each  member  of  the  original  group,  it  could  be  fore¬ 
told  how  much  would  have  to  be  paid  at  the  end  of  the  first  year  to  those 
surviving  at  that  time,  how  much  would  have  to  be  paid  at  the  end  of  the 
second  year  and  at  the  end  of  the  third  year,  and  so  on  throughout  the 
number  of  years  covering  the  possible  span  of  life  of  any  of  the  members 
of  the  group.  This  series  of  payments  may  be  compared  to  a  serial  bond 
issue  maturing  in  definite  amount  throughout  a  period  of  years.  And  just 
as  the  banking  house  computes  the  present  value  of  the  principal  payments 
under  the  serial  bond  issue,  so  the  actuary  computes  the  present  value  of 
the  series  of  annuity  payments  that  will  be  made  to  the  members  of  the 
annuity  group.  Dividing  the  present  value  of  the  complete  series  of  future 
annuity  payments,  by  the  original  number  of  members  of  the  group,  he 
arrives  at  the  true  present  value  of  the  life  annuity  on  the  basis  of  the 
mortality  table  employed  and  of  the  rate  of  interest  assumed  in  determining 
the  present  value  of  the  future  payments.1 

A  casual  inspection  of  the  table  on  page  278  explains  at  once  why  it  is 
that  few  annuities  are  sold  at  the  younger  ages.  The  percentage  return  at 

1  In  practice,  this  extended  method  of  computation  is  not  actually  required, 
since  mathematical  short  cuts  have  been  developed  which  greatly  facilitate  the 
actuarial  calculation.  The  final  results  of  the  short  method,  however,  are  identical 
with  those  obtained  by  the  extended  process  described . 


278 


RISK  AND  RISK-BEARING 


these  ages  is  not  sufficiently  in  excess  of  the  return  upon  funds  invested 
through  the  regular  channels  to  induce  prospective  annuitants  to  hazard 
the  loss  of  a  considerable  portion  of  their  principal  by  investing  in  an  annuity. 
At  the  older  ages,  however,  where  the  return  exceeds  say  8  per  cent,  the 
annuity  makes  its  greatest  appeal.  In  no  other  manner  can  a  sum  of  money 
be  invested  to  yield  an  absolutely  certain  life  income  of  so  large  an  amount. 


TABLE  SHOWING  COMPARATIVE  RETURNS  ON  MALE  AND  FEMALE 
ANNUITIES,  AVERAGE  OF  15  AMERICAN  COMPANIES 


Age 

Male 

Female 

15  American 
Companies 

15  British 
Companies 

15  American 
Companies 

15  British 
Companies 

Lowest 

5-40 

5-4i 

5-29 

5-21 

40 . 

• 

A verage 

583 % 

5-88% 

5-53% 

5-56% 

Highest 

6.29 

6.21 

6.08 

5-85 

Lowest 

6-57 

6.61 

6.22 

6.13 

50 . 

Average 

7  03% 

7 -14 % 

6-Si% 

6-59% 

Highest 

7-58 

7  -46 

7.07 

6.82 

Lowest 

8.55 

8-75 

7.89 

7.78 

60 . 

Average 

9-21% 

9-4t% 

8.31% 

8.36% 

Highest 

9.87 

9-63 

8.8  3 

8.58 

Lowest 

11 .91 

12.80 

11  -39 

11  33 

70 . 

A  verage 

13-27% 

U-73% 

H-94% 

12-14% 

Highest 

13-85 

14.00 

12.47 

12.35 

Lowest 

17.76 

16 . 57 

80 . 

A  verage 

10  ■  v>% 

17  ,6n% 

Highest 

22.47 

20.20 

Annuities  have  reached  their  greatest  development  in  older,  longer 
established  countries  where  there  are  large  accumulations  of  capital  and 
where  interest  rates  are  relatively  low.  Pioneer  countries,  where  available 
capital  is  urgently  needed  for  development  of  their  resources  and  where 
the  return  upon  investments  is  correspondingly  large,  know  little  of  annuities. 
For  this  reason,  America  has  had  less  experience  with  annuities  than  has 
Great  Britain. 

An  important,  but  less  well  known,  application  of  the  annuity  is  to  the 
problem  of  liberating  for  the  urgent  needs  of  the  present  capital  that  would 
otherwise  be  held  invested  because  of  the  income  it  produces.  An  excellent 
example  taken  from  the  literature  of  a  company  that  has  made  a  specialty 
of  the  annuity  business  will  serve  to  make  this  application  clear: 

A  father,  69  years  of  age,  had  two  sons,  one  a  lawyer,  age  27,  and  the 
other  a  doctor,  age  29.  Each  was  struggling  to  build  up  a  practice  in 
London.  The  father  realized  that  his  boys  were  then  more  in  need  of 
financial  assistance  than  they  were  likely  to  be  in  later  years  after  he  had 
passed  away.  His  income,  about  £400  a  year,  derived  from  investment 
of  £12,000,  was  just  sufficient  to  meet  his  own  requirements.  If  he  gave 
his  sons  any  of  the  capital  he  reduced  his  own  income.  He  solved  the 


LIFE  INSURANCE 


279 


difficulty  by  purchasing  an  annuity  of  £400  payable  £100  a  quarter.  This 
cost  him  about  £3,184  of  his  capital.  The  balance  of  £8,816  he  equally 
divided  between  his  sons,  enabling  the  doctor  to  move  to  Harley  Street, 
and  the  lawyer  to  secure  a  remunerative  partnership. 

The  deferred  annuity. — An  annuity  of  much  value  is  the  deferred  annuity. 
The  first  payment  under  this  annuity  is  deferred  for  a  period  of  years,  say 
to  the  end  of  the  annuitant’s  income-earning  period.  It  may  be  purchased 
by  a  single  premium  or  by  a  series  of  premiums.  Upon  the  death  of  the 
annuitant  the  contract  terminates.  For  an  additional  premium,  provision 
may  be  made  for  the  return,  upon  the  death  of  the  annuitant,  of  such  Dart 
of  the  premiums  as  may  not  have  been  returned  in  annuity  payments. 

The  deferred  annuity  is  particularly  adapted  to  men  and  women, 
without  present  or  prospective  dependents,  who  desire  to  provide  during 
their  income-earning  period  against  possible  dependency  in  old  age.  There 
is  no  more  economical  manner  in  which  this  provision  may  be  made;  though 
it  is  essential  if  there  be  dependents,  that  the  deferred  annuity  should  be 
supplemented  by  additional  provision  for  their  support.  To  meet  this 
latter  contingency,  contracts  involving  both  the  annuity  principle  and  the 
insurance  principle  have  been  developed. 

The  reversionary  annuity. — One  of  these  combination  contracts  devel¬ 
oped  to  meet  the  demand  for  a  method  of  protecting  a  dependent  in  the 
event  of  the  death  of  the  breadwinner,  is  the  reversionary  annuity  which 
provides  for  the  payment  of  a  life  annuity  to  a  beneficiary  commencing 
upon  the  death  of  a  designated  person  known  as  the  insured. 

For  example,  a  son  may  employ  the  reversionary  annuity  to  insure  a 
life  income  to  his  mother,  should  she  outlive  him.  The  contract  may  be 
paid  for  by  a  single  premium  01  by  a  limited  number  of  annual  premiums, 
continuing,  however,  only  so  long  as  the  mother  and  son  both  live.  Upon 
the  death  of  the  son,  the  annuity  payments  to  the  mother  commence. 
Should  the  mother  die  before  the  son,  the  contract  terminates  and  all 
premiums  paid  are  forfeited. 

Where  there  is  a  considerable  difference  in  the  ages  of  the  insured  and 
beneficiary,  the  reversionary  annuity  renders  its  greatest  service,  and 
under  these  circumstances  it  is  well  adapted  to  the  protection  of  the  older 
of  the  two  lives  in  the  event  of  the  death  of  the  younger.  Where  the  ages 
are  more  nearly  equal,  however,  or  where  the  beneficiary  is  younger  than 
the  insured,  the  reversionary  annuity  possesses  many  weaknesses. 

The  monthly  income  policy. — A  modified  form  of  the  same  contract  is 
the  monthly  income  policy.  The  monthly  income  policy  remedies  in  large 
measure  the  weakness  discovered  in  the  reversionary  annuity.  In  the 
first  place,  the  income  payable  upon  the  death  of  the  insured  under  a 
monthly  income  policy  is  payable  monthly  for  a  fixed  number  of  years 
certain  and  thereafter  during  the  remaining  lifetime  of  the  beneficiary.  By 
the  phrase  “fixed  number  of  years  certain”  it  is  meant  that  when  the 


RISK  AND  RISK-BEARING 


280 

income  becomes  payable  by  the  death  of  the  insured,  the  income  during 
the  so-called  “period  certain”  is  guaranteed  irrespective  of  the  life  of  the 
beneficiary.  On  this  account,  it  is  possible  to  change,  ad  libitum ,  the 
beneficiary  who  shall  receive  the  “income  certain”;  and  as  the  “period 
certain”  is  frequently  twenty  years,  the  privilege  is  a  valuable  one.  The 
income  payable  after  the  expiration  of  the  period  certain  is  usually  payable 
only  during  the  lifetime  of  the  beneficiary  originally  designated. 

Immense  improvement  of  the  income  policy  upon  the  reversionary 
annuity  is  that  it  protects  any  children  who  may  be  living  at  the  death  of 
the  insured.  The  fact  that  the  income  is  payable  certainly,  for  say  twenty 
years,  insures  that  the  children  will  receive  an  income  until  they  have 
acquired  an  education  and  have  become  self-supporting. 

Furthermore,  the  monthly  income  policy  possesses  a  cash  surrender 
value  based  upon  insurance  value  of  the  income  payable  during  the  period 
certain;  whereas  the  reversionary  annuity  makes  no  provision  for  cash 
surrender. 

The  most  complete  form  of  monthly  income  policy  adds  to  the  one  just 
described,  a  further  provision  under  which  the  income  commences  upon  the 
insured’s  living  a  specified  number  of  years,  or  say  to  age  sixty  or  sixty-five. 
In  this  event,  the  income  is  paid  to  the  insured  during  his  remaining  life¬ 
time,  and  after  his  death  to  the  beneficiary, ‘with  a  guaranty  that  payments 
for  a  period  certain  will  be  made  if  both  the  insured  and  the  beneficiary  die 
during  the  period.  If  the  insured  dies  before  the  date  when  his  income  is 
due  to  commence,  the  income  is  paid  to  the  beneficiary  for  life,  with  the 
guaranty  of  income  for  a  period  certain.  This  contract  is  adapted  to 
furnish  complete  protection  to  a  husband  and  wife,  and  also  protection, 
during  minority,  to  any  children  living  at  the  death  of  the  insured  or  at  the 
time  the  income  to  the  insured  commences.1 

Disability  clauses  in  life  insurance  policies  present  innumerable 
differences  of  detail,  but  fall  into  two  general  types.  Some  provide 
simply  for  the  cessation  of  premiums  during  the  continuance  of  total 
disability,  prior  to  a  specified  age,  usually  sixty  or  sixty-five.  Such  a 
provision  may  be  very  useful  in  enabling  the  insured  to  keep  his 
policy  in  force  at  a  time  when  he  is  unable  to  earn  anything,  but  its 
benefits  are  of  very  small  financial  significance,  as  the  average  length 
of  life  of  disabled  persons  below  age  sixty,  as  generally  estimated, 
is  less  than  a  year  and  a  half. 

The  second  type  of  disability  clause  provides  for  the  payment  of 
benefits  under  the  policy,  usually  in  instalments,  in  the  event  of  total 
and  permanent  disability.  A  great  variety  of  clauses  of  this  general 
type  are  offered.  Some  simply  provide  for  the  payment  of  the  face 

1  Adapted  by  permission  from  M.  A.  Linton,  “Life  Annuities,”  Annals  of  the 
American  Academy  of  Political  and  Social  Science ,  LXX  (March,  1917),  20-35. 


LIFE  INSURANCE 


281 


of  the  policy,  with  interest,  in  annual  or  more  frequent  instalments 
over  a  period  of  twenty  years,  from  beginning  of  total  disability,  with¬ 
out  regard  to  the  time  of  death  of  the  insured.  Others  provide  for 
payment  of  such  instalments  during  the  period  of  disability,  and  the 
payment  at  death  of  any  balance  remaining  unpaid  at  that  time.  Still 
others  provide  for  payment  of  the  instalments  during  continuance  of 
disability,  and  also  the  payment  of  the  full  amount  of  the  insurance 
at  death.  The  rates  also  vary  a  great  deal,  as  there  are  no  generally 
accepted  tables  indicating  the  extent  of  the  risk  insured  against  under 
these  clauses.  A  number  of  companies  are  using  their  own  experience, 
which  has  not  been  published. 

Disability  clauses  of  the  first  type,  those  providing  only  for 
cessation  of  premiums,  cost  very  little  (twelve  cents  per  thousand 
dollars  per  year  on  a  thirty-year  term  policy  at  age  thirty-five,  accord¬ 
ing  to  one  company’s  rates),  but  the  clauses  which  provide  for  the  pay¬ 
ment  of  disability  benefits  of  a  substantial  character  are  relatively 
expensive. 

Logically,  every  contract  of  life  insurance  should  contain  a  clause 
providing  for  the  payment  of  the  face  value,  either  in  cash  or  in 
instalments,  in  the  event  of  permanent  total  disability.  The  con¬ 
tingency  insured  against  in  a  life  policy  is  the  loss  of  income  due  to 
death.  The  loss  incurred  in  the  event  of  total  disability  is  of  the  same 
character  as  that  sustained  in  the  event  of  death,  and  is  even  greater 
in  amount,  for  the  cost  of  support  of  the  insured  individual,  which 
ceases  at  death,  continues  and  may  even  increase  at  disability.  In 
the  present  unstandardized  state  of  the  disability  clause,  however,  the 
disability  clause  requires  very  careful  scrutiny  in  order  that  the 
insured  may  be  assured  that  he  is  getting  value  equivalent  to  the  cost.1 

War  risk  insurance . — One  of  the  most  interesting  experiments  in 
recent  life  insurance  history  is  the  establishment  of  the  War  Risk 
Bureau  under  the  federal  government  to  furnish  life  insurance  for 
soldiers  and  sailors  during  the  Great  War.  The  idea  underlying  the 
establishment  of  this  type  of  insurance  was  that  the  soldier  or  sailor 
should  be  given  the  opportunity  to  secure  protection  for  his  dependents 
against  the  risk  of  death  during  military  service,  or  the  years  following, 
on  terms  which  would  throw  upon  the  government  the  cost  of  pro¬ 
tection  against  hazards  due  to  the  war,  while  the  individual  paid 

1  Leading  discussions  of  disability  clauses  are  Bruce  D.  Mudgett's  two  articles, 
“Total  Disability  Provision  in  American  Life  Insurance  Contracts,”  Annals  of  the 
American  Academy  of  Political  and  Social  Science,  Vol.  LIX  (May,  1915),  and  “Five 
Years’  Progress  in  Disability  Protection,”  ibid.,  Vol.  LXX  (March,  1917). 


2  82 


RISK  AND  RISK-BEARING 


the  cost  of  insuring  him  against  t’he  ordinary  hazards  of  peace.  This 
was  accomplished  through  the  creation  of  the  War  Risk  Bureau,  which 
undertook  to  write  life  insurance  on  the  entire  military  and  naval 
force.  The  policies  as  originally  written  were  five-year  term  policies, 
and  the  premiums  were  net  premiums  without  loading,  the  entire 
expense  of  administration  being  absorbed  by  the  government. 

As  the  mortality  during  the  war  was  very  high  and  was  expected 
to  be  still  higher,  there  was  no  expectation  that  the  premiums  would 
be  adequate  to  meet  the  losses.  The  government  spent  a  large  amount 
of  money  in  urging  those  eligible  to  take  advantage  of  the  insurance 
offered,. and  was  successful  in  writing  more  than  four  million  policies. 
As  soon  as  the  armistice  was  signed,  however,  the  greater  proportion  of 
the  policyholders  ceased  the  payment  of  premiums.  In  1919  it  was 
reported  that  less  than  a  million  policyholders  were  keeping  up  their 
payments.  In  order  to  check  the  decline  the  Secretary  of  the  Treasury 
issued  a  ruling  permitting  discharged  soldiers,  sailors,  and  marines 
who  had  dropped  or  canceled  their  policies  to  reinstate  within  eighteen 
months  after  discharge  without  medical  examination  and  without  the 
payment  of  back  premiums,  except  one  month’s  premium  to  cover  the 
period  of  grace  when  the  policy  was  in  force.  The  only  limitation  on 
the  privilege  was  that  the  applicant  should  be  in  as  good  health  as  he 
was  at  the  date  of  his  discharge.  In  spite  of  this  liberality  the  decrease 
in  number  of  policyholders  continued  so  that  only  about  550,000 
policies  are  now  in  force. 

As  a  very  large  proportion  of  the  holders  of  these  policies  were 
young  men  without  dependents,  who  in  the  normal  course  of  events 
would  not  have  been  in  the  market  for  insurance  for  some  time  and 
would  not  have  bought  $10,000  policies  for  many  years,  it  is  not 
strange  that  the  lapse  rate  has  been  very  high.  The  tendency  to 
discontinue  payment  of  premiums  was  aggravated  by  dissatisfaction 
over  the  large  number  of  errors  made  by  the  Bureau  and  the  extreme 
slowness  with  which  it  worked.  The  necessity  of  converting  the  term 
policies  into  higher-priced  policies  also,  in  all  probability,  contributed 
to  this  tendency  to  lapse,  as  did  the  very  liberal  policy  of  reinstatement. 

The  optional  conversion  privilege  offered  a  choice  of  whole  life 
policies,  twenty-  or  thirty-year  limited  payment  or  endowment 
policies,  and  endowments  maturing  at  age  sixty-two. 

Most  of  the  liberal  policy  features  developed  by  legislation  or  by 
the  competition  of  life  insurance  companies  in  recent  years  were 
included — high  loan  and  surrender  values,  option  of  monthly,  quar- 


LIFE  INSURANCE 


283 


terly,  or  annual  premium  payments,  exemption  of  proceeds  from  taxa¬ 
tion  and  from  the  claims  of  creditors,  and  incontestability  from  date 
of  issuance,  the  last  provision  one  which  seems  to  offer  an  unnecessary 
incentive  to  fraud.  The  disability  clause  is  extremely  liberal,  pro¬ 
viding  for  payment  of  $5.75  per  thousand  dollars  insurance  monthly 
for  the  period  of  total  disability,  or  for  240  months  in  case  of  death 
before  the  expiration  of  that  period.  Similar  clauses  in  private 
insurance  contracts  usually  cover  only  disability  incurred  before  a 
specified  age,  sixty,  sixty-five,  or  seventy  years.  In  view  of  the  very 
large  proportion  of  aged  persons  who  incur  disability,  this  feature  is 
of  considerable  importance. 

With  regard  to  the  success  of  the  government’s  experience  with 
life  insurance,  opinions  will  differ  for  many  years.  In  the  author’s 
judgment,  the  fundamental  principle  on  which  the  cost  was  divided 
between  the  insured  and  the  government  was  thoroughly  sound,  and 
the  object  aimed  at,  namely,  the  avoidance  of  the  pressure  for  pensions 
for  dependents  in  years  to  come,  was  an  eminently  worthy  object. 
In  view,  however,  of  the  progressive  liberalization  of  the  policy  and  the 
pressure  for  other  types  of  financial  assistance  to  veterans  of  the  war, 
it  appears  extremely  doubtful  whether  the  insurance  will  not  prove 
to  be  an  addition  to,  instead  of  a  substitute  for,  our  traditional  pension 
legislation. 

The  wisdom  of  handling  the  insurance  through  a  government 
bureau  is  more  debatable.  At  the  time  the  experiment  was  under¬ 
taken  no  life  insurance  company  was  in  a  position  to  handle  the 
volume  of  business  created  by  the  war  emergency,  and  few  companies 
would  have  cared  to  risk  the  loss  of  good  will  resultant  from  disrupting 
their  organizations  in  an  attempt  to  do  so.  As  the  number  of  the 
insured  grows  smaller,  however,  the  necessity  for  handling  this  pro¬ 
gram  through  a  government  bureau  grows  less.  From  a  purely  busi¬ 
ness  standpoint,  it  would  probably  be  desirable  to  transfer  the  con¬ 
tracts  in  time  to  a  syndicate  of  insurance  companies  if  it  were  politically 
feasible  to  do  so.  No  such  action  appears  probable,  however. 

The  chief  criticisms  which  may  fairly  be  leveled  at  the  insurance 

*  t 

administration  have  to  do,  not  with  the  routine  clerical  labor  but  with 
matters  of  policy.  In  the  first  place,  the  selling  methods  which  have 
at  times  been  used  by  the  Bureau  have  been  the  subject  of  well- 
merited  criticism.  For  instance,  in  1918,  a  circular  issued  by  the  Bu¬ 
reau  set  forth  the  claim  that  the  government  policy  offered  insurance 
at  a  rate  30  per  cent  below  that  offered  by  any  commercial  company, 


284 


RISK  AND  RISK-BEARING 


a  figure  which  was  apparently  arrived  at  by  treating  a  policy  for 
$10,000  payable  in  monthly  instalments  over  a  period  of  twenty  years 
as  the  equivalent  of  a  policy  for  $10,000  payable  in  cash,  without 
regard  for  the  item  of  interest. 

The  exclusion  of  term  insurance  from  the  list  of  policies  to  be 
issued  after  live  years  from  the  close  of  the  war,  is  also  hard  to  justify. 
Term  policies  are  not  popular,  the  candidate  for  insurance  being  apt 
to  infer  that  if  he  lives  out  the  term  of  the  contract  he  has  given 
something  for  nothing.  The  hostility  of  most  insurance  companies 
to  term  insurance  has  encouraged  this  attitude.  The  War  Risk 
Bureau  had  an  opportunity  to  do  an  excellent  piece  of  educational 
work  on  this  point,  but  has  chosen  instead  to  adopt  the  traditional 
viewpoint,  treating  the  term  policy  as  a  makeshift  and  urging  early 
conversion  into  the  more  “permanent”  types  of  investment  policy. 

As  already  noted,  the  feature  of  incontestability  from  date  of 
issuance  seems  to  be  unnecessarily  liberal,  and  to  offer  incentive  to 
fraud.  The  complete  exemption  of  the  proceeds  of  policies  from  all 
claims  of  creditors  enlarges  upon  a  bad  custom.  Such  exemption  is 
very  general,  so  far  as  life  policies  payable  to  dependents  are  con¬ 
cerned;  the  government  policy  offers  such  protection  even  to  the 
proceeds  of  endowment  policies.  There  is  little  justification  for  such 
exemption  in  any  case,  and  least  in  the  case  of  endowments. 

Sweeping  statements  by  the  Bureau  that  the  government  will 
never  turn  this  business  over  to  private  companies,  while  they  will 
probably  be  justified  by  the  results,  do  not  seem  to  be  justified  by 
the  present  legal  situation.  There  is  no  legal  difficulty  in  the  way  of 
any  future  Congress  abolishing  the  Bureau,  and  either  turning  the 
insurance  over  to  private  companies  or  canceling  the  policies  and  pay¬ 
ing  the  policyholders  the  cash  surrender  value  of  their  insurance. 
Such  an  action  seems  at  the  present  time  politically  impossible,  but 
in  view  of  the  startling  changes  of  political  outlook,  which  frequently 
take  place  in  a  few  years,  the  positive  statements  to  the  contrary  by 
the  Bureau’s  representatives  are  hardly  justified. 

From  the  standpoint  of  the  insured,  the  war  risk  policy  is  decidedly 
attractive.  In  the  first  place,  it  offers  a  standard  policy  at  net  table 
rates,  the  lowest  rates  at  which  non-participating  insurance  can  be 
offered  by  a  legal  reserve  company.  Second,  the  policy,  as  already 
noted,  contains  a  very  liberal  disability  clause,  for  which  no  allowance 
is  made  in  figuring  the  premium.  This  feature  makes  the  policy  the 
cheapest  insurance  of  its  type  in  the  market.  Third,  the  policy  is 


LIFE  INSURANCE 


285 


a  participating  policy,  sold  at  non-participating  rates.  To  be  sure, 
this  feature  does  not,  on  the  face  of  things,  appear  to  be  of  much 
importance,  for  of  the  three  chief  sources  of  dividends  on  insurance 
policies,  only  one  appears  to  be  available  in  connection  with  the  war 
risk  policy.  There  can  be  no  savings  from  expense  loading,  for  there  is 
no  loading.  Mortality  savings  appear  very  remote,  for  the  experience 
during  the  war  was  very  unfavorable,  and  the  present  list  of  policy¬ 
holders  contains  a  high  proportion  of  disabled  veterans,  among  whom 
the  mortality  must  be  excessive.  There  remains  the  possibility  of 
gains  from  investments.  The  statement  of  assets  and  liabilities  as 
of  December  31,  1921,  showed  total  assets  in  the  government  life 
insurance  fund,  amounting  to  $45,515,362.12,  over  $42,000,000  of 
which  was  invested  in  United  States  bonds  (book  value).  Assuming 
earnings  of  4J  per  cent  on  the  entire  body  of  assets,  the  gross  invest¬ 
ment  earnings  would  be  less  than  $2,000,000,  of  which  amount  over 
$1,000,000  is  required  for  interest  accumulation  on  the  policy  reserve 
of  $29,387,889,  leaving  less  than  $1,000,000  to  offset  excess  mortality 
and  provide  for  dividends.  Yet  $1,750,000  was  shown  in  the  same 
statement  as  reserved  for  dividend  payments  during  1922.  In 
the  absence  of  definite  information  as  to  the  way  in  which  earnings 
have  been  figured,  it  is  difficult  to  resist  the  conclusion  that  such 
distributions  as  have  been  made  were  based  rather  on  political  expedi¬ 
ency  than  on  bona  fide  earnings.1 

This  last  point  suggests  a  fourth  advantage  of  a  war  risk  policy, 
from  the  standpoint  of  the  holder,  namely  its  speculative  value,  which 
arises  from  the  uncertainty  which  exists  concerning  future  changes  in 
the  rights  and  obligations  of  the  policyholder.  That  future  legislation 
will  reduce  the  benefits  to  be  derived  from  the  ownership  of  these 
policies  seems  highly  improbable,  while  there  is  a  considerable  chance 
that  changes  may  be  made  which  will  reduce  the  premium  payments 

1  The  dividends  paid  in  1922  ranged  from  $1.53  to  $2.04  per  $1,000  of  insurance 
on  ordinary  life  policies,  and  from  $1.68  to  $213  on  twenty-year  endowments. 
Inquiry  from  the  War  Risk  Bureau  concerning  the  source  of  dividend  earnings  has 
elicited  only  the  information  that  “the  fund  from  which  dividends  on  converted 
policies  may  be  apportioned  is  accumulated  from  two  sources:  savings  due  to 
deferred  mortality  and  excess  interest  earnings.”  On  the  other  hand,  a  pamphlet 
issued  by  the  War  Risk  Bureau  in  1920  stated  that  more  than  $1,000,000,000  in 
claims  had  been  allowed,  and  only  about  $300,000,000  had  been  collected  in  pre¬ 
miums.  New  and  Liberal  Features  of  War  Risk  Insurance,  p.  7.  It  is  of  course 
possible  that  the  1922  dividends  were  based  on  1921  mortality  experience,  without 
consideration  of  the  accumulated  excess  mortality. 


286 


RISK  AND  RISK-BEARING 


or  increase  the  benefits.  Under  our  system  of  government,  the  odds 
in  such  a  speculation  are  all  in  favor  of  the  holder.  He  has  a  hand  in 
the  treasury,  and  the  longer  he  holds  his  policy,  and  the  more  generally 
his  fellows  surrender  theirs,  the  more  valuable  does  his  position  become. 
From  a  purely  financial  point  of  view,  therefore,  it  seems  clear  that 
any  holder  of  a  war  risk  policy  who  now  has,  or  expects  ever  to  have, 
need  of  insurance,  has  much  to  gain  and  little  to  lose  by  keeping  his 
policy  in  force. 


QUESTIONS 

1.  Explain  the  meaning  of  the  following  terms:  adverse  selection,  benefit 
of  selection,  reserve,  loading. 

2.  What  are  the  advantages  of  each  of  the  leading  types  of  “old  line”  life 
insurance  policy? 

3.  Why  should  the  cost  of  insurance  in  the  later  years  of  life,  under  the 
natural  premium  plan,  become  prohibitive  ?  Is  insurance  bought  more 
cheaply  by  paying  for  it  years  in  advance  ? 

4.  Calculate  the  value  of  your  own  life  for  insurance  purposes,  making 
reasonable  assumptions  concerning  your  prospective  earnings  and  per¬ 
sonal  expenditures. 

5.  At  what  time  of  life  is  the  maximum  amount  of  insurance  necessary  in 
order  to  cover  the  amount  at  risk  ? 

6.  How  much  insurance  is  it  good  business  policy  to  keep  in  force  on  the 
life  of  a  retired  business  man  ?  Does  the  state  of  his  health  at  the  time 
of  his  retirement  have  any  bearing  on  the  answer  ? 

7.  An  unmarried  woman,  35  years  of  age,  a  teacher,  is  the  sole  support  of 
her  mother,  aged  73.  She  is  advised  to  take  out  $4,000  of  twenty-year 
term  insurance,  and  $4,000  of  twenty-payment  life  insurance,  in  order 
to  combine  protection  for  her  mother  with  provision  for  her  own  old  age. 
Could  you  give  her  better  advice?  (Her  salary  is  $1,750  per  annum). 

8.  A  and  B  are  brothers,  sons  of  C,  a  widower.  C  at  age  65  notifies  A  and  B 

that  he  will  no  longer  keep  up  premium  payments  on  two  policies  in  their 
favor  on  his  life,  one  of  which  is  an  ordinary  life  policy  in  a  legal  reserve 
company,  taken  out  at  age  35,  the  other  a  beneficial  certificate  in  a 
fraternal  order,  taken  out  at  age  28.  Both  the  insurance  company  and 
the  fraternal  order  bear  good  reputations.  C  is  in  excellent  health.  A 
and  B  are  in  no  way  dependent  on  C’s  income,  which  is  chiefly  derived 
from  investments,  though  he  earns  enough  to  pay  his  living  expenses  from 
the  practice  of  a  profession.  The  rate  on  the  fraternal  certificate  is  $9  00 
per  thousand,  on  the  old-line  policy  $21.00.  A  and  B  decide  to  keep  up 
the  payments  on  both  contracts.  Is  this  decision  wise  ( a )  in  the  case  of 
the  legal  reserve  policy  ?  ( b )  in  the  case  of  the  fraternal  benefit  certifi¬ 

cate  ? 


LIFE  INSURANCE 


287 


In  the  case  above  cited,  three  years  after  the  brothers  assume  responsi¬ 
bility  for  the  premium  payments,  A  proposes  to  B  to  sell  his  interest  in 
the  fraternal  policy.  C  is  still  in  good  health.  The  following  bargain 
is  struck:  B  is  made  sole  beneficiary.  B  is  to  pay  A  the  present  worth 
of  half  the  face  of  the  policy,  discounted  at  an  agreed  rate  of  interest  for 
the  term  of  C’s  life  expectancy  as  shown  by  the  American  Experience 
Mortality  Table,  less  the  present  worth  of  the  premiums  on  the  half 
policy  which  would  fall  due  within  said  life  expectancy. 

Is  this  a  fair  bargain  ?  If  not,  what  other  factors  should  be  taken 
account  of  to  determine  a  fair  price  for  A’s  interest  ? 


CHAPTER  XIV 


FIRE  INSURANCE 

Of  the  various  types  of  property  insurance,  fire  insurance  is  much 
the  most  important  from  the  standpoint  of  the  amount  of  insurance 
written  and  the  number  of  individuals  protected.  The  usual  types 
of  fire  insurance  transaction  will  therefore  be  discussed  in  some  detail, 
leaving  other  kinds  of  property  insurance  to  be  dealt  with  more  briefly 
in  chapter  xv,  chiefly  by  comparison  of  their  practice  with  that  of 
fire  insurance. 

The  subject-matter  of  this  chapter  will  be  discussed  in  accordance 
with  the  following  outline: 

I.  The  risk  insured 

II.  Policy  contracts 

III.  Special  provisions  in  insurance  contracts 

1.  The  mortgage  clause 

2.  Coinsurance 

3.  Three-quarter  loss  clauses;  three-quarter  value  clauses 

4.  Use  and  occupancy,  profit,  and  rent  insurance. 

IV.  Company  organization 

1.  Stock  companies 

2.  Mutual  companies 

3.  Lloyds  associations 

4.  Reciprocal  insurance 

V.  Rates  and  rate-making 

1.  Methods  of  rating:  judgment,  schedule,  experience  rating 

2.  Rate  schedules:  the  Universal  Mercantile;  the  Dean 

I.  THE  RISK  INSURED 

The  risk  covered  by  fire  insurance,  the  hazard  of  loss  from  the 
destruction  of  property  by  accidental  or  incendiary  fire,  is  one  of  the 
most  serious  risks  with  which  business  has  to  contend.  The  extremely 
destructive  character  of  accidental  fires,  the  frequency  with  which 
they  occur,  the  irregularity  in  the  incidence  of  the  loss,  and  the  con¬ 
stant  change  in  the  character  of  the  hazard  combine  to  make  the  prob¬ 
lem  of  elimination  of  fire  risk  one  of  the  most  difficult  in  the  whole 
field  of  business.  The  advance  of  civilization  has  brought  about  a 
great  improvement  in  the  techniques  of  fire  prevention  and  the  fight- 


288 


FIRE  INSURANCE 


289 


ing  of  fires,  but  it  has  also  brought  in  innumerable  new  hazards. 
Each  change  in  the  methods  of  heating,  lighting,  building,  in  the  kind 
of  power  used  in  manufacture,  in  the  methods  of  transportation 
employed,  in  short,  in  almost  any  phase  of  the  industrial  and  com¬ 
mercial  life,  brings  new  hazards.  The  substitution  of  electric  lighting 
for  kerosene  lamps  reduced  the  number  of  fires,  but  it  resulted  in  a 
larger  proportion  of  very  destructive  fires,  because  fires  resulting  from 
faulty  wiring  are  more  likely  to  remain  undiscovered  till  they  have 
gained  headway.  Railway  transportation  brought  in  the  hazard  of 
fires  from  sparks;  automobile  transportation  is  bringing  new  hazards 
from  the  storage  of  fuel.  The  transition  of  the  United  States  from  a 
rural  to  an  urban  civilization  made  possible  a  great  improvement 
in  fire  protection  and  encouraged  more  substantial  construction,  but 
led  to  a  concentration  of  risks.  The  net  result  was,  on  the  one  hand, 
to  bring  about  a  great  increase  in  the  proportion  of  trifling  fires,  and, 
on  the  other  hand,  to  increase  the  hazard  of  conflagration.  The  fire 
loss  fluctuates  widely  from  year  to  year  and  from  community  to 
community,  some  of  its  vagaries  being  quite  inexplicable. 

There  is  a  striking  parallel  between  the  fire  loss  and  the  cost  of 
depreciation.  Both  the  deterioration  due  to  weathering  and  the 
loss  due  to  fire  are  inevitable  costs  of  doing  business.  Both  involve 
the  ultimate  destruction  of  the  capital  exposed  to  them  and  hence 
require  the  occasional  investment  of  large  sums  for  replacement  pur¬ 
poses.  The  most  important  difference  between  them  is  that  depre¬ 
ciation  goes  on  at  a  rate  sufficiently  uniform  to  enable  a  fairly  accurate 
calculation  of  the  time  at  which  the  replacement  will  be  necessary 
while  fire  loss  is  highly  irregular.  Hence,  it  is  more  practicable  to 
make  provision  for  depreciation  through  setting  aside  annually  a 
designated  sum  out  of  earnings.  If  the  amount  of  a  corporation’s 
property  exposed  to  fire  is  great  enough  and  the  sweep  of  time  involved 
in  the  calculation  extensive  enough,  it  is  possible  to  make  provision 
for  destruction  by  fire  in  the  same  way.  The  number  of  risks  and  the 
range  of  time  involved  in  most  men’s  calculations,  however,  are  not 
great  enough  to  make  such  replacement  practical,  hence  the  payment 
of  insurance  by  numerous  firms  into  a  common  fund  is  necessary  in 
order  to  equalize  the  burden.  Like  the  depreciation  charge,  the  insur¬ 
ance  premium  is  an  annual  contribution  out  of  the  gross  income  for 
the  replacement  of  wasting  capital,  and  through  the  medium  of  insur¬ 
ance,  or  through  the  diversification  which  is  occasionally  possible,  an 
analogous  degree  of  regularity  in  its  incidence  is  secured. 


2QC 


RISK  AND  RISK-BEARING 


The  principal  elements  which  make  up  the  fire  hazard  on  any 
property  are  the  construction,  the  occupancy,  the  protection,  the 
exposure,  and  the  moral  hazards.  Construction  and  occupancy  are 
self-explanatory.  The  chief  points  of  importance  in  connection  with 
construction  are  the  combustibility  of  materials  and  the  readiness  with 
which  flames  can  spread  from  one  part  of  the  building  to  another. 
Occupancy,  so  far  as  the  hazard  of  the  building  is  concerned,  is  chiefly 
important  from  the  standpoint  of  the  tendency  of  the  processes 
carried  on  to  cause  fires  to  originate,  though  the  tendency  of  the  con¬ 
tents  to  transmit  fire  readily  is  also  an  important  factor.  In  insuring 
the  contents  of  a  building,  attention  must  also  be  given  to  a  third 
factor,  the  extent  to  which  the  contents  are  susceptible  to  damage 
either  from  fire  or  from  smoke,  water,  dirt,  and  exposure  incident  to 
removal  on  account  of  fire. 

“Protection”  is  the  term  appliedito  the  facilities  available  for  stop¬ 
ping  the  progress  of  fires.  It  includes  both  the  public  fire-fighting 
service  and  the  provision  made  in  connection  with  the  property  itself, 
such  as  automatic  sprinklers,  fire  pails,  services  of  watchmen,  etc. 

The  term  “exposure”  refers  to  the  risk  of  damage  through  fire 
originating  outside.  Nearly  30  per  cent  of  fires  are  due  to  exposure; 
hence  careful  attention  must  be  given  to  such  factors  as  distance  from 
neighboring  buildings,  location  of  windows,  character  of  processes 
carried  on  in  adjacent  buildings,  and  similar  sources  of  risk. 

One  phase  of  the  exposure  hazard  is  of  so  much  importance  as  to 
deserve  special  discussion.  This  is  the  so-called  conflagration  hazard, 
the  risk  of  a  fire  so  serious  as  to  outrun  the  fire  fighting  facilities  of  a 
city  and  burn  itself  out  without  effective  opposition.  The  distribu¬ 
tion  of  the  loss  due  to  conflagrations  constitutes  one  of  the  most  diffi¬ 
cult  problems  in  insurance  policy.  Conflagrations  do  not  occur  with 
sufficient  frequency  or  regularity  do  make  possible  an  accurate  esti¬ 
mate  of  the  amount  of  loss  which  may  be  anticipated  on  account  of 
them.  The  period  of  time  required  to  determine  the  statistical  fre¬ 
quency  of  so  infrequent  a  phenomenon  as  a  two  million  dollar  fire  is 
so  great  that  before  sufficient  data  can  be  assembled  conditions  change 
and  the  earlier  experience  becomes  valueless.  Before  every  great 
conflagration  in  recent  years,  it  has  been  argued  that  the  improvements 
in  fire  protection  and  the  regulation  of  building  construction  had  so 
reduced  the  conflagration  hazard  of  the  larger  cities  as  to  make  it 
negligible.  During  the  past  few  years,  comparative  immunity  has 
in  fact  been  obtained,  but  it  will  be  many  years  before  it  can  safely  be 


FIRE  INSURANCE 


291 


said  that  experience  has  confirmed  the  conclusions  of  those  who  deny 
the  continued  significance  of  the  conflagration  hazard. 

It  is  almost  impossible  to  make  satisfactory  provision  for  meeting 
this  kind  of  fire  risk.  Fire  insurance  rates,  as  a  whole,  are  based  on 
regional  experience,  and  the  experience  of  most  sections  of  the  country 
has  not  included  a  conflagration  so  recently  that  its  effect  shows  in 
the  tables  of  average  losses.  Sections  which  have  had  conflagrations, 
on  the  other  hand,  object  to  having  their. rates  based  on  the  heavy 
loss  ratio  which  results  from  averaging  in  the  conflagration  losses 
with  the  minor  losses  which  occur  from  year  to  year,  arguing  rightly 
that  the  fact  of  a  conflagration’s  destroying  the  major  part  of  a  given 
city  does  not  create  a  presumption  of  a  heavier  loss  ratio  in  succeeding 
years  for  the  whole  state  or  other  geographical  subdivision  in  which 
the  city  happens  to  be  located.  Moreover,  if  rates  were  so  adjusted 
as  to  take  care  of  the  full  risk  of  loss  due  to  conflagration  hazard,  and 
no  conflagration  occurred  for  many  years,  it  would  be  difficult  to  pre¬ 
vent  stockholders,  buyers  of  insurance,  and  taxing  bodies  from  drawing 
the  conclusion  that  the  large  excess t  revenues  resulting  from  the  high 
rates  were  a  profit  available  for  distribution  as  dividends.  The  only 
way  companies  can  protect  themselves  is  to  keep  their  risks  so  scat¬ 
tered  that  no  single  conflagration  can  wipe  out  their  surpluses,  then 
if  heavy  losses  are  incurred  charge  them  to  surplus  as  business  losses. 
Usually,  after  a  great  conflagration,  a  number  of  companies  go  into 
bankruptcy,  thereby  throwing  part  of  the  loss  on  policyholders,  and 
frequently  rates  are  raised  for  a  time  to  enable  the  surviving  companies 
to  recoup  themselves.  This  is  quite  justifiable,  so  far  as  urban  proper¬ 
ties  are  concerned,  but  the  increasing  of  rates  on  rural  property,  not 
subject  to  conflagration  hazard,  in  order  to  take  care  of  the  losses  due 
to  a  great  conflagration,  involves  a  real  injustice. 

The  moral  hazard  includes  both  the  danger  of  deliberate  destruc¬ 
tion  of  property,  caused  either  by  the  owner,  in  order  to  collect  insur¬ 
ance,  or  by  others  out  of  spite,  and  the  hazard  due  to  carelessness. 
The  moral  hazard  is  greater  in  fire  insurance  than  in  most  kinds  of 
insurance,  because  of  the  ease  with  which  property  can  be  burned,  and 
the  difficulty  with  which  companies  are  able  to  protect  themselves 
by  preventing  overinsurance.  Only  a  small  proportion  of  insured 
properties  are  inspected  to  guard  against  overinsurance  at  the  time 
policies  are  taken  out,  and  even  where  this  is  done  there  is  great  diffi¬ 
culty  in  precluding  the  later  appearance  of  overinsurance  through 
depreciation  of  buildings,  price  changes,  decline  of  prosperity  of  the 


292 


RISK  AND  RISK-BEARING 


community  or  of  the  individual  concern,  or  changes  in  building  or 
contents  made  by  the  owner.  Hence,  there  is  a  constant  temptation 
to  policyholders  to  recoup  their  business  losses  or  rid  themselves  of 
unsalable  property  by  arson,  and  a  still  greater  temptation  to  neglect 
precautions  which  would  probably  be  taken  if  the  fire  hazard  repre¬ 
sented  a  real  risk  to  the  owners. 

The  importance  of  the  moral  hazard  is  easily  exaggerated,  how¬ 
ever.  Its  importance  does  not  consist  in  the  number  of  fires  which 
are  caused  through  moral  shortcomings,  but  rather  in  the  necessity 
of  constant  watchfulness  and  effort  to  prevent  an  increase  in  their 
number.  Unless  nearly  all  the  fires  due  to  unknown  causes  (usually 
about  15  per  cent  of  the  total)  are  due  to  incendiarism,  the  proportion 
of  losses  due  directly  to  moral  hazard  is  relatively  small.1 

What  risks  are  insurable  ?  As  was  noted  in  chapter  xiii,  the  the¬ 
ory  of  insurance  is  that  the  effect  of  the  contract  is  to  relieve  the  insured 
from  the  risk  of  financial  loss  due  to  the  event  insured  against,  and  not 
to  guarantee  him  a  certain  sum  of  money  inthe  event  of  certain  things 
happening.  In  fire  insurance  this  is  known  as  the  doctrine  of  indem¬ 
nity.  On  account  of  the  great  moral  hazard  in  this  type  of  insurance, 
it  is  especially  important  that  the  insured  be  not  given  an  opportunity 
to  profit  by  the  occurrence  against  which  insurance  is  sought.  The 
results  of  this  situation  are,  first,  a  strict  application  of  the  requirement 
of  insurable  interest  on  the  part  of  the  insured;  second,  strict  pro¬ 
vision  that  overinsurance  shall  not  create  a  claim  for  compensation 
in  excess  of  the  loss  actually  sustained,  even  in  the  event  of  total  loss; 
third,  the  concept  of  insurance  as  a  personal  contract,  designed  to  off¬ 
set  a  given  individual’s  personal  risk,  and  not  transferable  except  with 
the  express  permission  of  the  insurer. 

The  doctrine  of  insurable  interest  means  simply  that  the  insured 
shall  have  an  actual  financial  interest  in  the  event  insured  against. 
If  such  interest  exists,  it  is  immaterial  whether  the  insured  is  the  actual 
owner  of  the  property  or  not.  Insurable  interest  includes  those  of 
mortgagees,  tenants,  agents,  common  carriers,  warehousemen,  con¬ 
tractors,  receivers,  and  many  others.2 

If  insurable  interest  does  not  exist  the  contract  creates  a  specula¬ 
tion  on  the  part  of  the  insured.  As  has  been  noted  previously,  such 

1  About  10  per  cent  of  fires  are  attributed  to  incendiarism.  It  is  frequently 
stated  that  industrial  depressions  cause  an  increase  in  the  fire  loss,  which  is  appar¬ 
ently  due  to  the  decline  in  value  of  property  and  the  increased  financial  pressure. 
The  statistics  of  fire  losses  afford  little  support  for  this  line  of  reasoning,  however. 

2  For  detailed  analysis  see  Huebner,  Property  Insurance,  chap.  iii. 


FIRE  INSURANCE 


293 


a  speculation  is  always  unfavorable  to  the  insured  and  favorable  to 
the  insurer,  unless  the  insured  either  has  knowledge  superior  to  that  of 
the  insurer  or  has  the  power  to  control  the  outcome.  In  tornado 
insurance,  the  insurance  companies  can  well  afford  to  write  insurance 
in  unlimited  amount,  if  their  rates  are  properly  adjusted  and  their 
risks  are  well  scattered.  But  in  fire  insurance  the  insured  often  has 
superior  knowledge  of  certain  elements  of  risk  and  nearly  always  has 
some  opportunity  to  exert  control  over  the  outcome;  hence,  it  is 
extremely  important  that  his  interest  in  the  policy  be  limited  to  the 
amount  which  he  actually  has  at  risk. 

This  limitation  is  regularly  secured  by  the  contractual  stipulation 
that  in  the  event  of  total  loss  only  such  amount  shall  be  payable  as 
represents  the  actual  value  at  the  time  of  the  fire.  In  some  states, 
however,  this  provision  has  been  set  aside  by  the  enactment  of  what 
are  known  as  valued  policy  laws.  The  effect  of  such  a  law  is  to  require 
the  insurance  company,  in  case  of  a  total  loss,  to  pay  the  full  amount  of 
the  policy,  irrespective  of  the  question  whether  the  property  was 
worth  that  much  or  not.  Thus  it  puts  the  burden  on  the  insurance 
company,  in  cases  where  overinsurance  is  claimed,  to  prove  actual 
fraud  instead  of  leaving  open  the  easier  defense  of  disputing  the  value 
of  the  property. 

Such  legislation  is  strongly  opposed  by  insurance  companies  and 
by  insurance  authorities  generally,  on  the  ground  that  it  is  a  deliberate 
encouragement  to  overinsurance  and  to  the  wilful  destruction  of 
property.  Advocates  of  such  legislation,  on  the  other  hand,  contend 
that  in  the  absence  of  a  valued  property  law,  insurance  companies 
can  collect  premiums  for  excess  insurance,  keep  the  premiums  in  the 
cases  where  no  loss  occurs,  and  in  cases  where  the  property  is  actually 
destroyed,  evade  the  payment  of  part  of  the  face  of  the  policy  by 
raising  the  issue  of  overinsurance  and  refunding  the  excess  premium. 

There  is  a  certain  amount  of  force  in  this  contention,  but  since 
no  one  is  under  obligation  to  take  out  more  insurance  than  he  has 
reason  to  think  he  can  collect  in  the  event  of  total  loss,  the  insurance 
company  has  the  better  case.  Valued  policy  laws,  undoubtedly, 
increase  the  moral  hazard,  and  do  not  carry  with  them  sufficient  com¬ 
pensating  advantages  to  justify  their  enactment. 

The  third  result  of  the  concept  of  insurance  as  indemnity  is  to  make 
it  strictly  a  personal  contract,  by  which  is  meant  that  the  insurance 
company  assumes  responsibility  only  for  the  loss  accruing  to  a  desig¬ 
nated  individual  or  firm.  Hence,  in  the  event  of  a  sale  or  other  change 


294 


RISK  AND  RISK-BEARING 


of  interest  on  the  part  of  the  insured,  the  insurance  never  follows  the 
property,  and  may  be  assigned  only  with  the  written  consent  of  the 
insurer.  Such  provisions  are  especially  necessary  in  types  of  insur¬ 
ance,  like  fire  insurance,  where  the  moral  hazard  is  great,  but  their 
application  is  not  limited  to  those  particular  types. 

Who  needs  fire  insurance?  All  who  own  property  subject  to 
damage  by  fire  have  a  risk  to  carry,  but  not  all  such  individuals  can 
wisely  cover  this  risk  by  insurance.  As  in  all  types  of  insurance,  it  is 
necessary  that  the  insured  group,  as  a  whole,  shall  pay  into  the  insur¬ 
ing  organization  more  than  they  withdraw  in  payment  of  losses.  The 
economic  value  of  the  institution  arises  from  the  two  circumstances: 
first,  that  a  single  large  loss  is  apt  to  be  more  disastrous  than  an  equiva¬ 
lent  amount  lost  in  a  series  of  small  items,  and  second,  that  an  unex¬ 
pected  loss  is  apt  to  be  more  serious  in  its  effects  than  one  which  is 
known  and  planned  for  in  advance. 

The  advisability  of  a  given  individual’s  carrying  any  sort  of  prop¬ 
erty  insurance  depends  entirely  upon  the  proportion  between  the  prob¬ 
able  amount  of  his  loss,  in  case  luck  runs  against  him,  and  the  total 
resources  from  which  the  loss,  if  it  occurs,  will  have  to  be  subtracted. 
This  comparison  reduces  itself  chiefly  to  a  question  of  the  extent  to 
which  one’s  resources  are  concentrated  so  as  to  be  exposed  to  the  hazard 
of  a  single  disaster.  It  is  not  at  all  a  question  of  the  financial  strength 
of  the  property  owner,  except  in  so  far  as  greater  financial  strength 
increases  the  probability  that  one’s  resources  will  be  scattered.  A 
corporation  which  owns  $1,000,000  worth  of  inflammable  goods,  all 
under  a  single  roof,  cannot  afford  to  leave  them  uninsured  any  more, 
nor  any  less,  than  can  an  individual  who  has  only  $1,000  worth  of 
goods,  all  under  the  same  roof.  In  each  case,  the  loss  which  is  rea¬ 
sonably  probable  is  sufficient  to  wipe  out  the  capital  and  interrupt 
the  course  of  business,  causing,  in  addition  to  the  direct  damage  a  loss 
of  good  will  and  destruction  of  earning  capacity.  Even  though,  in  a 
series  of  years,  the  amount  paid  in  by  the  insured  in  premiums  exceeds 
the  amount  which  could  have  been  lost  by  a  single  fire,  the  prevention 
of  these  indirect  losses  makes  the  transaction  worth  while.  On  the 
other  hand,  a  corporation  or  individual  having  $100,000  worth  of 
property  scattered  in  a  hundred  separate  lots,  in  different  cities,  has 
little  need  for  fire  insurance,  unless  some  of  the  units  exposed  to  a  single 
possible  fire  are  disproportionately  large.  The  distribution  of  risk 
secured  by  such  holdings  is  less  complete  than  that  secured  by  a  com¬ 
pany  which  insures  thousands  of  separate  properties,  but  the  loss  in  any 


FIRE  INSURANCE 


295 


year  is  not  likely  to  equal  many  times  the  total  amount  of  the  premi¬ 
ums  which  would  have  to  be  paid  to  secure  insurance.  The  fact  that 
the  loss  from  one  fire  will  be  small  relative  to  the  total  worth  of  the 
business  means  that  the  company  has  the  same  sort  of  protection  from 
indirect  losses  that  a  company  with  more  concentrated  resources  would 
have  to  secure  through  insurance.  Whenever  the  property  owner 
can  put  in  sufficient  outside  capital  to  replace  his  property  without 
seriously  upsetting  his  established  plans  of  operation  elsewhere,  he 
can  avoid  the  indirect  losses  at  the  point  where  the  fire  occurs  just  as 
well  as  though  he  replaced  his  capital  by  the  investment  of  money 
coming  from  an  insurance  company.  Thus,  railway  companies  have 
no  need  to  insure  their  smaller  station  buildings,  though  their  large 
city  terminals  may  advantageously  be  insured. 

Corporations  which  practice  self-insurance,  as  the  practice  of 
carrying  one’s  own  risk  is  called,  should  protect  themselves  against 
sudden  calls  for  capital  to  replace  fire  losses  by  maintaining  reserves 
in  the  form  of  marketable  securities  or  other  liquid  assets  which  can 
be  drawn  upon  for  the  purpose. 

IT.  POLICY  CONTRACTS 

One  outstanding  difference  between  the  situation  in  fire  insurance 
and  that  in  life  insurance  is  the  relative  degree  of  standardization  which 
has  been  attained.  The  legal  reserve  life  insurance  companies  all 
use  the  same  mortality  tables  and  approximately  the  same  interest 
rates,  and  the  principal  types  of  contract  which  are  offered  by  one 
company  are  offered  by  nearly  all.  The  effect  of  competition,  how¬ 
ever,  has  been  to  develop  a  large  number  of  contracts  differing  from 
one  another  in  relatively  unimportant  details.  These  details  are  then 
used  as  selling  points  to  establish  the  superiority  of  one  company’s 
offerings  over  those  of  another.  There  is  a  constant  stream  of  new 
types  of  disability  clauses,  double  indemnity  for  accident,  variant 
methods  of  treating  the  distribution  of  dividends,  and  variant  methods 
of  paying  the  proceeds  of  the  policy.  The  elements  with  which  the 
actuary  deals  are  so  few  that  the  really  important  variations  in  the 
contract  are  not  numerous,  but  the  exercise  of  salemen’s  ingenuity 
has  sufficed  to  create  an  appearance  of  wide  diversity. 

In  fire  insurance,  on  the  other  hand,  although  the  experience  of 
different  companies  has  not  been  pooled  so  as  to  establish  any  satis¬ 
factory  basis  for  standardizing  the  premium  charge,  the  effect  of 
competition  has  been  just  the  opposite  to  its  effect  in  life  insurance, 


296 


RISK  AND  RISK-BEARING 


namely,  to  bring  about  a  very  high  degree  of  standardization,  both  of 
the  terms  of  the  policy  contract  and  of  the  premiums  charged.  To 
some  extent  this  standardization  has  been  the  result  of  legislation 
requiring  the  use  of  standard  types  of  policy,  but  in  general  the  causal 
influence  has  operated  in  the  opposite  direction.  That  is,  it  has  been 
the  initiative  of  the  insurance  companies  which  has  led  to  the  uniform¬ 
ity  in  legislation  rather  than  the  legislation  which  has  brought  the 
companies  into  line.  Such  diversity  in  contracts  as  exists  at  the  pres¬ 
ent  time  is  due  more  to  the  divergence  of  ideas  among  legislators  and 
insurance  commissioners  in  different  states  than  it  is  to  a  difference 
in  the  attitude  of  insurers  themselves. 

This  difference  in  the  effect  of  competition  on  the  form  of  the  con¬ 
tract  is  apparently  due  to  a  difference  in  the  attitude  of  most  purchasers 
of  insurances  toward  the  two  types  of  contract.  Fire  insurance  is 
regarded  as  a  necessity  by  most  property  owners,  and  competition 
between  companies  consists  largely  of  a  competition  between  agents 
to  get  to  the  prospective  customer  first.  In  life  insurance,  on  the 
other  hand,  there  is  very  little  spontaneous  consumer  demand,  and 
insurance  is  sold  not  so  much  by  getting  to  the  consumer  first  as  by 
holding  on  to  him  longest.  Hence,  the  possession  of  a  special  feature 
which  can  be  played  up  as  a  talking  point  in  making  the  payment  is 
desirable  from  the  standpoint  of  the  life  insurance  agent,  whose  job 
is  primarily  one  of  creating  interest,  while  in  the  case  of  fire  insurance 
a  divergence  of  the  individual  policy  from  that  usually  written  would 
merely  create  additional  work  for  the  salesmen  in  explaining  the  varia¬ 
tion  to  a  customer  who  is  ready  to  buy  before  he  is  approached. 

Whatever  the  explanation,  the  tendency  toward  extreme  standard¬ 
ization  in  the  fire  insurance  contract  is  very  clear.  The  policy  most 
frequently  written  is  the  New  York  standard  policy,  which  has  been 
adopted  without  material  modification  in  most  states.  The  principal 
provisions  of  this  policy  may  be  summarized  as  follows: 

1.  As  previously  noted,  the  policy  insures  only  against  damage 
sustained  by  the  insured  or  his  legal  representatives. 

2.  The  policy  covers  loss  sustained  by  fire  and  by  removal  of  goods 
from  premises  endangered  by  fire,  but  does  not  cover  currency,  deeds, 
accounts,  money,  notes,  or  securities,  nor  does  it  cover  damages  caused 
directly  or  indirectly  by  invasion,  insurrection,  riot,  and  similar  dis¬ 
turbances. 

3.  The  policy  is  rendered  void  by  the  placing  of  other  insurance  on 
the  same  property  without  the  consent  of  the  insurer.  This  provision 
is  not  intended  to  discourage  the  distribution  of  insurance  between 


FIRE  INSURANCE 


297 


different  insurers,  but  simply  to  enable  the  insuring  companies  to  keep 
track  of  the  amount  of  insurance  outstanding.  Permission  to  place 
other  insurance  is  always  given  as  a  matter  of  course  unless  its  effect  is 
to  increase  the  total  amount  beyond  what  the  insurers  consider  con¬ 
servative  limits. 

4.  The  insurance  company  is  relieved  from  liability  during  the 
continuance  of  certain  conditions  which  operate  to  increase  the  hazard, 
including  alterations  of  the  building  (requiring  more  than  fifteen  days 
for  completion),  storage  of  certain  inflammable  compounds,  operation 
of  factory  buildings  at  night,  vacancy  of  building  beyond  ten  days, 
and,  in  general,  any  condition  known  to  the  insured  which  increases 
the  hazard  beyond  that  contemplated  when  the  amount  of  premium 
was  agreed  upon. 

5.  Both  parties  to  the  contract  reserve  the  right  of  cancellation 
at  will.  In  case  the  contract  is  canceled  by  the  insurance  company 
the  insured  is  entitled  to  return  of  the  full  proportion  of  premium  not 
yet  earned,  but  in  case  of  cancellation  by  the  insured  he  is  entitled  only 
to  the  difference  between  the  premium  he  has  paid  and  the  “short 
rate”  for  the  period  during  which  protection  has  been  enjoyed. 

6.  In  case  property  at  the  time  of  damage  is  covered  by  more  than 
one  policy,  the  loss  is  divided  among  the  insurers  in  proportion  to 
their  total  liability.  In  case  some  of  the  insurers  are  unable  to  meet  their 
liability,  which  is  likely  to  be  the  case  in  the  event  of  conflagration, 
the  other  insurers  are  liable  only  for  their  proportion  of  the  total,  not 
simply  the  collectible  insurance. 

7.  The  insurance  company  is  entitled  to  an  assignment  of  any 
rights  of  recovery  the  insured  may  possess  against  any  party  for  loss 
or  damage,  to  the  extent  that  payment  is  made  by  the  company. 
This  is  known  as  subrogation. 

8.  Detailed  provisions,  which  need  not  be  summarized  here, 
establish  the  requirements  in  case  of  loss,  including  notice,  proof  of 
loss,  protection  of  salvaged  property,  appraisal,  method  of  payment, 
etc.  The  company  reserves  the  option,  rarely  used,  of  replacing  the 
property  instead  of  paying  the  loss,  but  the  insured  does  not  have  the 
option  of  abandoning  the  property  to  the  company  and  claiming  a 
total  loss. 

The  indorsement  which  fits  the  standard  policy  to  the  conditions 
of  a  particular  risk  is  known  as  the  rider  form.  This  indorsement 
includes  the  name  of  the  insured,  the  character  of  his  interest  in 
the  property,  and  the  description  of  the  property  insured.  These 
forms  are  standardized,  to  a  large  extent,  and  serve  as  the  basis 


298 


RISK  AND  RISK-BEARING 


of  a  classification  of  policies  according  to  the  character  of  the  coverage. 
A  specific  policy  covers  a  definite  item  or  group  of  items  in  a  definite 
place.  A  general  policy  covers  different  kinds  of  property  in  a  specific 
place,  the  amount  of  each  being  specified.  A  blanket  policy  covers 
different  kinds  of  property  or  property  in  different  places  under  one 
item,  the  amount  of  each  remaining  unspecified.  A  distribution  clause 
in  a  blanket  policy  provides  that  in  the  case  of  two  or  more  lots  not 
subject  to  the  same  hazard  the  insurance  shall  apply  to  each  lot  in  the 
proportion  that  its  value  bears  to  the  value  of  the  entire  group  of  items 
covered.  A  floating  policy  follows  goods  in  transit.  An  excess  floater 
indemnifies  the  owner  to  the  extent  that  specific  insurance  carried 
may  at  the  time  of  the  loss  be  insufficient  to  cover  the  amount  of  the 
loss.  It  may  apply  at  one  or  at  several  locations. 

III.  SPECIAL  PROVISIONS  IN  INSURANCE  CONTRACTS 

To  the  standard  policy,  standardized  riders  may  be  attached 
covering  such  matters  as  the  protection  of  the  mortgagee,  protection 
against  gas  explosions,  permission  to  store  kerosene,  gasoline,  and 
other  inflammable  commodities  upon  the  property  in  excess  of  the 
amount  permitted  by  the  standard  policy,  vacancy  permits,  etc.,  and 
special  modifications  may  be  made  to  take  care  of  matters  not  covered 
by  the  standard  policy.  Of  these  special  provisions  some  of  the  most 
important  are  the  following: 

The  mortgage  clause. — There  are  several  ways  in  which  the 
interests  of  a  mortgagee  may  be  protected.  He  may  himself  take  out 
insurance  to  protect  his  own  interest;  he  may  receive  an  assignment 
of  the  insurance  from  the  mortgagor;  or  he  may  be  protected  by 
indorsement  of  the  policy  creating  a  claim  in  his  behalf.  The  legal 
effect  of  these  various  devices  has  been  interpreted  quite  differently 
in  different  jurisdictions,  and  as  a  result  there  has  been  developed  a 
standardized  mortgage  clause,  which  is  generally  considered  the  most 
satisfactory  method  of  protecting  the  interests  alike  of  mortgagor 
and  mortgagee.  This  clause  provides,  first,  that  the  insurance  shall 
be  payable  to  the  mortagee,  as  his  interest  may  appear;  second,  that 
the  rights  of  the  mortgagor  shall  not  be  invalidated  by  any  act  of 
the  mortgagee,  nor  by  change  of  title,  increase  of  hazard,  failure  of 
payment  of  premium;  third,  that  the  mortgagee  must  on  demand  pay 
any  premiums  which  are  not  paid  by  the  owner,  and  shall  notify  the 
company  of  any  change  in  hazard  or  condition  voiding  the  policy  which 
comes  to  his  knowledge  and  pay  any  increased  premium  necessitated 
by  such  conditions;  fourth,  that  in  case  of  cancellation  of  the  policy  by 


FIRE  INSURANCE 


299 


the  insurance  company  the  mortgagee  is  entitled  to  ten  days’  notice, 

instead  of  the  five  days’  notice  required  in  other  cases  of  cancellation. 

These  provisions  seem  extraordinarily  favorable  to  the  mortgagee  and 

unfavorable  to  the  insurance  company,  but  they  are  almost  necessary 

if  the  mortgagee’s  interest  is  to  be  protected,  since  it  is  impossible  for 

*■ 

him  to  control  all  the  conditions  which  may  operate  to  invalidate  a 
policy,  when  the  property  is  in  the  hands  of  the  mortgagor.  In  other 
words,  there  is  a  large  element  of  risk  against  which  neither  the  insur¬ 
ance  company  nor  the  mortgagee  can  guard;  the  effect  of  this  clause 
is  to  put  this  class  of  risks  on  the  insurer  so  long  as  the  mortgagor  acts 
in  good  faith.  In  case  the  clause  operates  to  create  a  claim  on  behalf 
of  the  mortgagee  under  a  policy  which  would  not  be  valid  against  the 
mortgagor,  the  insurance  company  is  subrogated  to  the  claim  of  the 
mortgagee  against  the  mortgagor,  to  the  extent  of  the  amount  it  has 
paid.  In  other  words,  if  the  insurance  company  has  to  pay  a  debt  for 
a  debtor  who  has  not  complied  with  the  conditions  necessary  to  keep 
his  policy  in  force,  the  insurance  company  succeeds  to  the  mortgagee’s 
position  as  a  creditor.  On  the  other  hand,  if  payments  are  made  under 
this  clause  to  a  mortgagee  under  a  policy  which  is  fully  valid,  the  debtor 
is  entitled  to  have  such  payments  credited  as  payments  on  the  debt 
which  the  mortgage  secures. 

Coinsurance. — Coinsurance  is  a  device  adopted  to  protect  insur¬ 
ance  companies  from  a  kind  of  adverse  selection  which  arises  in  com¬ 
munities  where  most  losses  are  partial.  Under  this  clause  the  insured 
property  owner  can  collect  for  partial  losses  only  in  the  proportion  that 
the  insurance  actually  carried  by  him  bears  to  a  certain  percentage  of 
the  value  of  the  property.  Insurance  to  the  amount  of  this  required 
percentage  is  nominally  required,  but  the  policyholder  is  under  no 
compulsion  to  buy  it;  if  he  carries  a  smaller  amount  he  is  himself  a 
coinsurer  for  the  balance  up  to  the  stipulated  percentage.  The  effect 
of  the  clause  may  be  illustrated  by  the  following  cases: 


Value  of  Property 

Coinsurance 

Clause 

Insurance 

Carried 

Loss 

Amount 

Collectible 

$10,000 . 

Per  Cent 

80 

$4 , OOO 

$1 ,000 

$  500 

10,000 . 

80 

4,000 

7,500 

3,750 

10,000 . 

80 

4,000 

8,000 

4,000 

10,000 . 

80 

4,000 

9,000 

4,000 

10,000 . 

80 

8,000 

1,000 

1,000 

10,000 . 

80 

8,000 

9,000 

8,000 

10,000 . 

IOO 

4,000 

1 ,000 

400 

10,000 . 

IOO 

4,000 

9,000 

3 ,6od 

300 


RISK  AND  RISK-BEARING 


In  case  of  total  loss,  the  coinsurance  clause  has  no  effect  on  the  amount 
payable. 

The  argument  in  favor  of  the  clause  is  briefly  as  follows:  In 
cities  where  there  is  good  fire  protection,  and  particularly  in  buildings 
where  parts  of  the  property  are  separated  by  fireproof  walls,  the  prob¬ 
able  amount  of  the  loss  from  a  given  fire  is  not  large  in  proportion 
to  the  value  of  the  property.  In  fact,  taking  the  experience  of 
insurance  companies  throughout  the  country  into  consideration,  the 
proportion  of  total  losses  is  not  above  5  per  cent,  and  in  centers  where 
the  insurance  protection  is  good  it  runs  much  below  that  figure.  In 
the  absence  of  a  coinsurance  clause,  the  effect  of  this  large  proportion 
of  partial  losses  is  to  make  partial  insurance  nearly  adequate  to  pro¬ 
tect  the  property  owner,  and  to  make  additional  insurance  after  the 
probable  loss  has  been  covered  extremely  expensive  in  proportion  to 
the  risk.  If,  for  instance,  an  individual  insures  property  worth  $10,000 
for  $3,000,  he  is  protected  fully  against  probably  three-fourths  of  the 
hazards  his  insurance  is  intended  to  cover.  Another  $3,000  insurance 
is  much  less  expensive  for  the  company  to  furnish  and  protects  him 
against  a  much  less  serious  risk.  The  additional  $4,000  necessary  to 
protect  his  property  fully,  protects  him  against  a  still  more  remote 
hazard,  in  many  cases  against  little  more  than  the  risk  of  conflagration, 

A  more  logical  method  of  meeting  this  situation  would  be  to  split 
the  risk,  charging  a  different  rate  for  successive  increments  of  insurance 
so  that  a  small  policy  would  be  paid  for  in  proportion  to  the  risk  it 
imposed  upon  the  insurer.1  A  coinsurance  clause  accomplishes  the 
same  purpose  in  a  simple  way  by  making  it  practically  necessary  for 
the  insured  to  take  out  a  sufficient  amount  of  insurance  to  satisfy  the 
requirements  of  the  underwriters. 

The  commonest  form  of  coinsurance  is  probably  the  80  per  cent 
clause,  although  requirements  run  all  the  way  from  40  to  roo  per  cent. 

When  property  covered  by  blanket  policies  is  scattered  in  dif¬ 
ferent  localities  or  the  contents  of  a  given  building  are  stored  in 
compartments  entirely  separated  from  one  another  by  fireproof 
walls,  the  case  for  coinsurance  is  the  strongest.  No  company  could 
afford  to  write  blanket  insurance  without  some  sort  of  protective 
clause  on  property  stored  in  this  way.  Before  the  introduction  of  the 
coinsurance  clause,  it  was  the  practice  to  require  a  separate  specific 
insurance  on  each  compartment,  but  this  was  awkward  and  it  was 
frequently  the  case  that  property  was  shifted  so  frequently  from  one 

1  This  method  is  used  in  insuring  fireproof  buildings,  under  the  Universal 
Mercantile  Schedule. 


FIRE  INSURANCE 


3QI 


compartment  to  another  that  it  was  impossible  to  adjust  the  premiums 
and  the  losses  equitably.  This  was  especially  true  in  the  case  of  manu¬ 
facturing  enterprises  where  the  raw  materials  went  in  process  from  one 
section  of  the  plant  to  another. 

The  coinsurance  clause  is  compulsory  in  many  European  countries, 
but  in  this  country  it  has  not  been  made  compulsory  and  in  many  states 
has  been  prohibited  by  law  or  discouraged  through  administrative 
rulings. 

Three-quarter  loss  and  three-quarter  value  clauses. — The  hazard 
involved  in  insuring  rural  property  is  quite  different  from  that  con¬ 
nected  with  urban  risks.  The  chief  difference  arises  from  the  fact  that 
the  proportion  of  total  losses  is  much  greater  in  the  case  of  rural  prop¬ 
erty.  This  is  true  because  frame  construction  is  more  common  in 
rural  than  in  urban  architecture,  because  farm  buildings  are  more 
likely  to  be  left  unobserved  long  enough  for  a  fire  to  gain  headway,  and 
most  important  of  all  because  of  the  lack  of  fire  protection.  Thus  the 
moral  hazard  is  rendered  more  serious  in  the  case  of  rural  than  with 
urban  property,  for  it  is  only  in  the  case  of  total  losses  that  there  is 
much  danger  of  the  company’s  being  called  upon  to  pay  materially 
more  than  the  amount  actually  lost. 

The  result  of  the  circumstances  just  outlined  is  that  instead  of 
encouraging  full  insurance  by  coinsurance  clauses  and  similar  devices 
the  primary  interest  in  rural  insurance  is  to  keep  the  amount  of  insur¬ 
ance  relatively  low  in  proportion  to  the  value  insured.  In  regions 
where  insurance  experience  has  been  unfavorable  and  the  proportion 
of  total  losses  is  high,  insurers  find  it  desirable  to  include  in  policies  a 
clause  limiting  liability  to  three-quarters  the  value  of  the  property, 
or  in  still  more  drastic  form,  to  three-quarters  the  amount  of  the  loss. 

Use  and  occupancy ,  profit,  and  rent  insurance: — As  has  been  noted, 
the  standard  fire  insurance  policy  covers  only  the  destruction  and 
damage  which  result  directly  from  fire,  or  from  efforts  to  extinguish 
fire  or  rescue  property  from  its  effects.  It  does  not  provide  for  the 
personal  or  business  losses  which  may  result  from  interruption  of  the 
use  of  the  property.  Yet  these  indirect  losses  are  of  considerable 
volume,  occasionally  indeed  almost  as  significant  as  the  direct  loss 
of  property.  If,  for  instance,  a  canning  factory  is  destroyed  by  fire 
at  the  beginning  of  its  active  operating  season  and  the  full  value  is 
promptly  paid  by  the  insurance  company,  the  delay  incident  to 
investing  the  proceeds  in  a  new  building  and  new  equipment  will 
probably  mean  the  loss  of  an  entire  year’s  profits  together  with  the 
indirect  costs  incident  to  maintaining  the  organization  during  the 


302 


RISK  AND  RISK-BEARING 


period  of  interrupted  production.  Likewise,  the  destruction  of  a 
merchant’s  stock  of  goods,  even  though  the  goods  are  replaced  within 
a  reasonable  time,  may  well  mean  the  loss  of  one  turnover  from  the 
year’s  business. 

To  provide  for  such  indirect  losses  as  these,  a  number  of  special 
types  of  insurance  have  been  devised  which  may  be  attached  to  the 
standard  policy,  or  may  be  written  as  separate  policies.  Use  and 
occupancy  insurance,  or  as  it  is  sometimes  more  clearly  designated, 
“business  interruption  insurance,”  is  written  on  buildings,  and 
provides  protection  (a)  against  the  loss  of  anticipated  profit  on  goods, 
the  production  of  which  is  prevented  by  the  occurrence  of  a  fire; 
( b )  against  the  loss  of  fixed  charges  and  expenses  necessarily  continued 
during  such  interruption;  but,  (c)  not  to  exceed  a  specified  proportion 
(usually  3^)  of  the  amount  of  the  use  and  occupancy  insurance 
for  each  working  day  lost.  Fixed  charges  and  expenses  include,  for 
purposes  of  this  type  of  insurance,  not  only  ordinary  salaries,  rentals, 
and  maintenance  of  property,  but  also  such  items  as  taxes,  interest, 
insurance  premiums,  royalties,  and  advertising  expense. 

Profit  insurance  is  written  on  merchandise  held  for  sale,  and 
covers  the  loss  of  profit  which  might  reasonably  have  been  anticipated 
from  the  sale  of  the  goods  destroyed.  A  similar  policy  is  written  to 
protect  commission  merchants  against  the  loss  of  commissions  on 
goods  consigned  to  them. 

Rent  insurance  is  written  in  a  variety  of  forms.  It  includes 
insurance  to  protect  a  landlord  against  the  loss  of  income  during  the 
period  when  his  property  is  untenable  on  account  of  fire;  “leasehold 
insurance,”  payable  to  a  tenant  to  protect  him  against  the  risk  of 
having  to  pay  higher  rental  during  an  interruption  of  his  tenure  of 
property  held  under  lease,  or  to  protect  his  profits  from  subleasing; 
and  “rental  value  insurance,”  which  protects  an  owner  occupying 
his  own  building  against  the  risk  of  having  to  pay  rent  elsewhere 
while  his  building  is  being  repaired  or  rebuilt. 

Use  and  occupancy,  rent,  and  profit  insurance  are  increasing  rapidly 
in  popularity;  a  further  increase  in  their  use  seems  probable,  as  they 
become  better  known,  for  they  furnish  protection  against  a  hazard 
which  is  quite  as  inescapable  as  is  the  fire  hazard  itself. 

IV.  COMPANY  ORGANIZATION 

Stock  companies. — The  dominant  type  of  fire  insurance  organiza¬ 
tion  is  the  ordinary  stock  corporation,  organized  for  profit.  It  is 


FIRE  INSURANCE 


303 

customary  to  combine  the  business  of  fire  insurance  with  marine  insur¬ 
ance,  and  frequently  other  types  of  property  insurance  are  also  written. 

As  in  life  insurance,  it  is  customary  to  accumulate  a  large  surplus 
to  serve  as  a  secondary  reserve  against  extraordinary  losses,  and  in 
the  case  of  old  companies  this  surplus  may  come  to  be  much  larger 
than  the  capital  stock.  In  the  early  history  of  a  company,  no  great 
amount  of  capital  is  needed,  and  under  ordinary  conditions  it  is  pos¬ 
sible  to  expand  the  surplus  out  of  earnings  as  fast  as  the  capital  needs 
expand.  The  chief  function  of  the  surplus  is  to  provide  a  reserve  for 
the  conflagration  hazard,  which  is  a  much  more  serious  hazard  than 
the  corresponding  catastrophe  hazard  in  any  other  form  of  insurance 
(except  crop  insurance). 

Just  as  is  the  case  in  life  insurance,  the  insuring  company  is  required 
to  hold  reserves  against  its  policies,  which  are  not  the  property  of  the 
company,  but  of  the  policyholders.  In  the  case  of  an  insurance  com¬ 
pany,  it  is  not  considered  necessary,  however,  to  keep  a  separate 
account  of  the  reserve  on  each  policy.  The  reserve  consists  simply 
ot  the  premium  paid  in  advance  for  which  no  protection  has  yet  been 
given;  hence  can  be  computed  for  the  group  of  similar  policies,  as  a 
whole,  more  readily  than  it  can  be  done  in  life  insurance  policies, 
where  the  reserve  arises  from  excess  premiums  paid  in  to  secure  low¬ 
ered  rates  many  years  in  the  future.  The  usual  custom  is  to  treat  all 
policies  issued  in  a  given  fiscal  year  as  though  they  were  issued  at  the 
beginning  of  that  year;  that  is,  to  hold  at  the  end  of  the  year  a  reserve 
of  one-half  the  premium  against  all  one-year  policies  issued  during  the 
current  year,  three-fourths  against  two-year  policies  issued  during  the 
year,  one-fourth  against  two-year  policies  issued  during  the  pre¬ 
ceding  year,  and  so  on.  This  method  works  out  slightly  in  favor  of 
companies  which  are  expanding  rapidly,  as  more  than  half  of  each 
year’s  business  is  likely  to  be  done  in  the  last  half  of  the  year,  so  the 
amount  actually  due  policyholders  as  unearned  premium  is  somewhat 
larger  than  the  reserve  figured  on  the  customary  basis. 

Mutual  insurance  companies. — The  two  most  important  groups 
of  mutual  fire  insurance  organizations  are  the  farmers’  mutuals  and  the 
factory  mutuals. 

The  Farmers’  Mutuals  constitute  one  of  the  best  examples  of  co¬ 
operative  enterprise  in  the  distribution  of  risks.  There  are  about  two 
thousand  of  these  organizations  in  the  United  States,  the  usual  scope 
of  their  operations  varying  from  a  township  to  several  counties.  Their 
organization  is  very  simple,  there  being,  as  a  rule,  only  one  or  two  paid 


304 


RISK  AND  RISK-BEARING 


officials  who  look  after  the  accounting,  collections,  settlements,  etc., 
while  an  executive  committee  which  receives  only  a  nominal  compensa¬ 
tion  passes  on  application  for  insurance  and  decides  matters  of  policy. 
The  method  of  operation  in  some  cases  is  to  collect  the  regular  premium 
charged  by  the  stock  companies,  and  then  make  rebates  to  members 
on  the  basis  of  the  percentage  saved.  In  other  mutuals  no  premiums 
are  collected  and  assessments  are  made  to  meet  claims  of  policyholders. 
Members  often  give  notes  for  a  fixed  sum,  which  is  the  limit  of  their 
liability. 

In  nearly  every  case,  the  insurance  written  is  limited  to  three- 
fourths  or  two-thirds  the  value  of  the  property  insured.  This  cir¬ 
cumstance,  together  with  the  fact  that  the  members  are  usually  well 
acquainted  with  one  another’s  business,  makes  the  moral  hazard  very 
low,  especially  in  those  mutuals  which  confine  their  operations  to  a 
unit  as  small  as  one  county.  Few  men  are  as  ready  to  try  to  throw 
an  illegitimate  loss  on  the  shoulders  of  their  neighbors  as  to  impose  it 
on  a  distant,  wealthy,  and  impersonal  stock  insurance  company. 

While  many  farm  mutuals  have  failed,  the  showing  of  the  group, 
as  a  whole,  is  creditable.  In  states  where  this  type  of  insurance  is 
highly  developed,  the  mutuals  have  effected  for  their  members’  savings 
amounting  to  more  than  half  the  rates  charged  by  the  stock  companies. 
This  saving  is  due  in  part  to  the  lower  loss  ratio,  due  to  superior 
inspection  and  lower  moral  hazard,  and  in  part  to  the  economy  of 
operation.  Just  as  is  the  case  with  fraternal  life  insurance,  the  sell¬ 
ing  costs  have  been,  in  large  part,  eliminated  by  the  co-operative  efforts 
of  the  members.  Mutuals  have  also,  in  most  cases,  received  special 
favors  from  the  state  in  the  form  of  tax  exemption.  Moreover,  the 
homogeneous  character  of  the  risks  they  insure  enables  them  to  avoid 
the  expense  of  maintaining  rating  bureaus,  compiling  experience  of  loss 
on  different  types  of  property,  and  other  expense  connected  with  the 
making  of  rates.  Finally,  it  is  probable  that  in  many  cases  the  owner 
of  farm  property  has  been  charged  a  rate  disproportionate  to  that 
charged  upon  certain  classes  of  urban  property.  Farm  mutuals,  by 
isolating  their  own  class  of  risks,  have  been  enabled  to  secure  insurance 
at  rates  which  give  them  the  full  benefit  of  their  immunity  from  con¬ 
flagration  hazard,  while  their  use  of  the  three-quarter  value  clause  has 
freed  them  from  much  of  the  disadvantage  resulting  from  the  high 
proportion  of  total  losses  which  characterizes  farm  property  insurance.1 

1  Cf.  V.  N.  Valgren,  “Farmers’  Mutual  Fire  Insurance,”  Year  Book  of  the 
Department  of  Agriculture ,  1916,  pp.  424-28. 


FIRE  INSURANCE 


305 


Factory  mutuals. — Outside  the  field  of  rural  insurance  the  most 
important  application  of  the  mutual  principle  in  fire  insurance  is  in 
the  field  of  factory  protection.  The  cotton-mills  of  New  England 
have  been  particularly  successful  in  reducing  the  cost  of  their  fire  pro¬ 
tection  through  mutual  insurance.  The  plan  of  organization  is  similar 
to  that  of  the  farmers’  mutuals  described  above.  The  factory  mutuals 
have  not  only  effected  great  reductions  in  the  cost  of  insurance  through 
economies  of  operation,  but  have  been  of  especial  value  on  account  of 
the  service  they  have  rendered  in  reducing  the  actual  fire  hazard. 
The  leading  factory  mutuals  co-operate  to  maintain  an  elaborate 
inspection  service  and  set  a  very  high  standard  of  fire  protection.  It 
is  said  that  their  activities  have  transformed  some  of  the  worst  of  fire 
traps  into  the  safest  kind  of  buildings  in  America.  As  a  rule  the 
factory  mutuals  collect  the  same  premium  that  the  stock  companies 
charge,  then  make  rebates  of  the  unused  premiums.  These  rebates 
frequently  run  to  50  per  cent  of  the  premium. 

Lloyd's. — A  Lloyd’s  Association  is  a  voluntary  association  of  indi¬ 
vidual  insurers  who  divide  among  themselves  the  risk  under  insurance 
contracts,  the  number  of  individual  insurers  and  the  proportion  of  risk 
taken  by  each  being  determined  separately  for  each  transcation.  The 
Association  itself  does  not  write  insurance;  it  simply  furnishes  a  place 
of  doing  business,  establishes  a  standard  form  of  policy,  arbitrates 
disputes,  and  looks  after  matters  of  mutual  interest  to  the  members. 

The  policy  written  at  Lloyd’s  is  very  simple  and  has  been  the 
subject  of  much  less  litigation  than  is  the  case  with  other  types  of  fire 
insurance  policy,  for  the  reason  that  it  is  the  regular  practice  for  no 
insurer  to  assume  liability  for  an  amount  large  enough  to  justify  his 
disputing  a  claim  except  in  cases  where  the  claim  is  obviously  unjusti¬ 
fied.  Proposals  for  insurance  are  made  to  the  insurers  through 
brokers,  and  the  insurers  sign  for  such  amount  as  each  of  them  sees 
fit  to  accept  at  the  price  agreed  upon.  In  case  any  insurer  repents 
of  his  bargain,  he  is  free  to  reinsure,  and  often  does  so  at  a  much  higher 
premium,  thus  passing  on  the  risk  or  distributing  it  over  a  wider  group 
of  insurers. 

By  far  the  most  important  of  the  Lloyd’s  Associations  is  the  origi¬ 
nal  London  Lloyd’s,  which  is  primarily  an  association  for  insuring 
marine  risks,  but  includes  in  its  activities  insurance  against  a  very 
wide  variety  of  hazards,  including  fire.  Most  of  the  American  Lloyd’s 
have  been  of  small  importance,  though  there  are  a  number  of  exceptions. 
The  London  Lloyd’s  does  a  large  volume  of  business  in  this  country. 


306 


RISK  AND  RISK-BEARING 


Lloyd’s  Associations  are  especially  important  as  a  source  of  insur¬ 
ance  against  unusual  hazards  which  ordinary  insurance  companies 
do  not  care  to  handle.  The  insurer  at  Lloyd’s,  being  a  private  indi¬ 
vidual  who  sets  his  own  standards,  can  take  chances  with  novel  types 
of  hazard  to  which  a  great  stock  company  would  find  it  very  difficult 
to  adapt  itself.  American  insurance  tradition  is  particularly  hostile 
to  the  acceptance  of  risks  of  such  unique  character  that  no  satisfac¬ 
tory  mathematical  estimate  of  the  hazard  can  be  made.  But  English 
insurers,  particularly  the  insurers  at  Lloyd’s,  have  exactly  the  opposite 
tradition,  and  will  furnish  insurance  against  almost  any  contingency. 
For  example,  during  the  Great  War,  Lloyd’s  insurance  was  regularly 
written  against  the  war  ending,  or  not  ending,  before  a  fixed  date. 
Much  Lloyd’s  insurance  is  written  against  such  contingencies  as  bad 
weather  on  holidays,  causing  loss  to  tradespeople.  A  Lloyd’s  repre¬ 
sentative,  in  a  western  city  a  few  years  ago,  worked  up  a  thriving  trade 
in  insuring  fur  coats  against  fire,  theft,  accidental  damage,  and  any 
unfortunate  event  not  due  to  the  will  of  the  owner.  One  applicant  is 
said  to  have  secured  a  Lloyd’s  policy  insuring  him  against  any  loss 
incurred  through  future  damage  suits  against  him  for  violence  he 
might  commit  in  a  fit  of  anger  against  one  of  his  family  connections. 

Reciprocal  insurance. — Reciprocal  or  interinsurance  against  fire 
is  a  development  of  the  co-operative  principle,  which  is  intermediate 
in  character  between  an  ordinary  mutual  and  a  Lloyd’s  organization. 
It  is  like  the  mutual  form  in  that  its  members  are  at  the  same  time 
insurers  and  insured,  and  in  some  of  its  forms  it  differs  little  from  the 
ordinary  factory  mutual;  in  other  cases  its  members  are  practically 
Lloyd’s  insurers  writing  policies  on  one  another’s  property.  The 
following  article  describes  the  reciprocal  organization  so  well  that 
further  description  is  unnecessary: 

A  reciprocal  or  inter -insurance  exchange  is  a  place  where  business  con¬ 
cerns  exchange  with  each  other  contracts  of  indemnity  against  lire  and  light¬ 
ning  (or  other  hazard)  for  certain  definite  amounts.  A  is  insured  by  B,  C, 
D,  and  E.  B  is  insured  by  A,  C,  D,  and  E.  C  is  insured  by  A,  B,  D,  and  E. 
D  is  insured,  by  A,  B,  C,  and  E.  E  is  insured  by  A,  B,  C,  and  D.  To  make 
the  exchange  of  contracts  each  applicant  for  insurance,  called  a  subscriber, 
gives  a  power  of  attorney  to  a  manager,  called  the  attorney-in-fact,  who 
conducts  the  exchange.  Suppose  101  concerns  are  to  make  the  exchange, 
each  having  authorized  the  attorney  to  bind  it  for  a  sum  not  to  exceed  $1,000 
on  each  risk.  If  Concern  No.  x  wishes  $110,000  of  insurance,  it  cannot  be 
had,  tor  fhere  are  only  100  other  subscribers.  It  can  get  a  $100,000  policy. 
The  standard  hre  policy  ot  the  state  in  which  the  applicant  resides  is  written 


FIRE  INSURANCE 


3°7 


up.  At  the  end  of  the  policy  a  clause  is  added  specifying  the  liability  of 
each  signer  to  be  one  one-hundredth  part  of  the  face,  or  $1,000,  and  the  signa¬ 
ture  of  each  of  the  hundred  other  concerns  is  affixed  by  the  attorney-in-fact. 
If  Concern  No.  2  desires  a  policy  for  $25,000,  it  is  signed  by  each  of  the  other 
concerns  under  a  final  paragraph  stating  that  the  liability  of  each  is  $250. 
If  there  are  412  subscribers  and  each  limits  his  liability  on  a  single  risk  to 
$2,000,  the  largest  policy  that  can  be  written  is  41 1  times  $2,000,  or  $822,- 
000;  on  a  policy  for  $25,000  the  liability  of  each  subscriber  would  be  $25,000 
divided  by  411,  which  is  $60.83.  The  amount  of  liability,  $100,  $250,  $500, 
$750,  $1,000,  $2,000,  $2,500,  or  $10,000,  which  a  subscriber  will  assume  on  a 
single  risk  is  specified  in  his  power  of  attorney. 

Subscriber' s  agreement  and  power  of  attorney. — It  would  be  inconvenient 
for  each  subscriber  to  receive  and  pass  on  every  application  for  insurance. 
Therefore  each  subscriber  delegates  the  power  to  examine  applications  and 
sign  policies  to  the  same  person,  the  attorney-in-fact,  who  is  the  manager  of 
the  exchange.  The  attorney  is  thus  enabled  to  do  business  for  all  in  one 
place  at  one  time.  The  instrument  which  each  subscriber  gives  him  is 
called  the  “subscriber’s  agreement  and  power  of  attorney.”  The  agreement 
and  the  power  may  be  separate,  but  usually  they  are  together  in  one  docu¬ 
ment.  This  instrument  specifies  all  the  details  of  the  method  and  prescribes 
the  duties  that  may  be  performed  for  the  subscriber  by  the  attorney-in-fact. 

Premiums  and  expenses. — The  premium  which  is  paid  in  advance  to  the 
manager  is  nearly  always  the  same  as  is  charged  by  the  stock  fire  insurance 
companies.  The  manager’s  compensation  is  a  commission  on  the  premiums. 
"This  commission  varies  according  to  the  character  of  the  business  of  each 
exchange.  Many  exchanges  have  it  fixed  at  25  per  cent;  a  wholesale  grocers’ 
exchange  operates  at  20  per  cent;  department  store  exchanges  get  off  at 
15  per  cent  or  even  10  per  cent.  What  this  compensation  covers  in  addition 
to  the  services  of  the  manager  is  illustrated  by  this  quotation  from  a  sub¬ 
scriber's  agreement: 

“It  is  expressly  agreed  and  understood  that  they  (the  managers)  shall, 
out  of  said  compensation,  themselves  defray  all  disbursements  of  every 
character,  except  losses,  counsel  fees,  costs  and  expenses  of  lawsuits,  taxes, 
legal  assessments,  expenses  of  fire  control,  fees  of  the  advisory  committee, 
and  all  expenses  incident  to  the  investment  and  custody  of  funds  and  securi¬ 
ties,  and  of  the  adjustment  of  losses.” 

The  manager  himself  pays  for  rent,  salaries,  traveling  expenses,  printing, 
supplies,  etc.  All  premiums  after  expenses  and  losses  have  been  deducted, 
belong  to  the  subscribers.  The  most  successful  group  of  inter  insurers  hav£ 
regularly  saved  for  themselves  85  per  cent  of  their  premiums  Another  group 
has  returned  amounts  equal  to  78  per  cent  of  the  premiums  received.  Some 
exchanges  report  savings  of  50  per  cent,  some  25  per  cent,  while  others  have 
failed  absolutely  and  produced  net  losses  to  their  members. 


RISK  AND  RISK-BEARING 


Separate  accounts  for  each  subscriber. — Since  the  premiums  are  the  prop¬ 
erty  of  the  separate  subscribers  (every  contract  examined  declares  there 
are  no  joint  funds),  separate  accounts  with  each  member  are  necessary.  Two 
different  methods  of  accounting  are  used.  Plan  One.  The  premium  of 
each  subscriber  is  held  in  trust  for  him.  Each  account  is  credited  with  the 
premium  received  and  with  the  earnings  from  the  investment  of  the  premium 
and  the  accumulated  surplus.  Each  account  is  debited  with  its  share  of 
expenses  and  losses.  The  balance,  if  there  is  a  credit  balance,  is  the  saving 
of  the  subscriber  from  the  premium  paid.  Plan  Two.  The  premium  paid 
by  a  subscriber  belongs  pro  rata  to  the  other  subscribers  who  have  signed  his 
policy.  Each  account  is  credited  with  its  share  of  every  premium  received 
and  with  the  earnings  from  the  investment  of  the  credit  balances.  Each 
account  is  debited  with  its  proper  share  of  expenses  and  losses.  The  credit 
balance,  if  there  is  one,  is  profit  realized  from  the  business  of  insuring  fellow- 
subscribers.  By  this  method  a  subscriber  who  carries  much  less  insurance 
than  his  fellow-members  may  receive  profits  greater  than  his  premiums. 

Reserve  against  unusual  losses. — It  is  a  common  rule  to  require  that  all 
savings  or  profits  be  allowed  to  accumulate  until  a  surplus  equal  to  double 
the  subscriber’s  risk  on  a  single  policy  is  provided. 

Payment  of  excess  losses. — If  current  losses  are  so  great  as  to  exceed  the 
amount  of  current  premiums  and  accumulated  profits, what  is  the  liability 
of  each  subscriber?  Some  reciprocals  place  no  limit  upon  their  right  to 
assess  subscribers.  Some  provide  that  each  insured  shall  not  pay  more 
than  his  annual  premium  on  any  one  risk;  some  that  he  shall  not  pay  more 
than  one  additional  premium  on  any  one  risk.  Such  provisions  still  leave 
no  limit  to  the  liability  for  aggregate  losses.  There  is  a  type  of  agreement 
in  use,  however,  that  attempts  to  restrict  aggregate  losses  to  the  annual  pre¬ 
mium  or  deposit,  by  means  of  payments  for  reinsurance.  The  exchanges 
writing  the  largest  hazards  provide  that  in  case  of  one  fire  involving  several 
risks  the  insurance  in  force  must  be  reduced  to  make  the  pro  rata  liability 
of  each  subscriber  no  more  than  a  multiple  of,  say,  four  or  five  times  the 
liability  on  each  risk.  The  aggregate  liability  in  the  case  of  many  single 
fires  is  still,  as  it  should  be,  unlimited.  Usually  the  subscriber  authorizes 
the  attorney,  in  the  event  that  the  surplus  is  insufficient  to  pa>  losses,  to 
draw  on  him,  and,  if  necessary,  sue  him  for  the  amount,  provided  the  maxi¬ 
mum  liability  of  the  subscriber  has  not  been  reached.  Sometimes  the  agree¬ 
ment  calls  for  a  flat  sum  to  be  paid  on  demand  in  case  of  excess  losses.  It 
is  always  possible  to  authorize  the  attorney  to  insure  the  subscriber  against 
excess  liability.  Some  of  the  exchanges  provide  regularly  for  the  deduction 
of  5  per  cent  of  the  premiums  to  take  care  of  this  cost  of  reinsurance.  Maxi¬ 
mum  liability  is  the  knottiest  problem  of  the  reciprocals.  Can  you  limit 
liability  and  still  have  good  insurance  ?  The  proper  solution  is  not  to  weaken 
insurance  by  attempting  to  restrict  liability  by  contract,  but  to  lessen  losses 
bv  sound  underwriting,  and  not  assume  the  hazard  of  conflagration.  Here 


FIRE  INSURANCE 


309 


is  one  such  plan:  “It  is  our  policy  not  to  write  more  than  the  equivalent 
of  one  risk  limit  in  any  one  city  block  or  square,  and  not  to  write  more  than 
the  equivalent  of  five  risk  limits  in  any  city.”  When  maximum  ‘imits  ace 
involved  the  subscriber  must  know  how  many  risks  are  about  him.  If  his 
contract  limits  his  liability  on  a  single  risk  to  $1,000  and  to  four  times  that 
on  a  single  fire,  and  there  are  eight  other  risks  in  that  area  besides  himself, 
he  is  only  one-half  insured  against  conflagration.  If  there  are  only  four 
other  risks  in  that  area,  he  is  insured  to  the  face  of  his  policy  even  if  a.  con¬ 
flagration  occurs. 

Special  class  insurance. — The  big  advantage  claimed  for  reciprocal 
insurance  is  that  it  is  more  economical.  How  is  it  possible  to  insure  for  less 
than  is  charged  by  the  stock  companies,  the  best  of  which  lead  the  world 
in  insurance  ability  ?  The  factory  mutuals  of  New  England  proved  that  if 
only  the  highest  class  risks  of  one  kind  were  studied  and  accepted  the  cost 
could  be  reduced.  This  idea  is  characteristic  of  the  best  reciprocals. 

An  examination  of  the  risks  of  reciprocals  shows  them  to  be  certain 
special  lines  such  as  bank  buildings,  steam  laundries,  steam  bakeries,  lum¬ 
ber  mills,  wholesale  houses,  drug  stores,  hotels,  and  department  stores. 
An  inter-insurer  of  hotels  and  drug  stores  says:  “We  write  only  upon  build¬ 
ings  of  brick,  stone  or  fireproof  construction  and  the  contents  therein,  in 
towns  or  cities  with  adequate  fire  protection.”  One  exchange  advertises 
the  following  safeguards:  “Elimination  of  moral  hazard;  wide  separation 
of  risks;  rigid  inspections;  thorough  equipment  of  automatic  sprinklers — 
no  exceptions.”  The  manager  of  another  exchange  says:  “The  principal 
features  that  make  for  the  success  of  our  insurance  are  the  following:  No 
concern  worth  less  than  $125,000  is  eligible  on  account  of  the  assessment 
feature;  in  other  words,  he  must  be  strong  enough  financially  to  meet  an 
assessment  of  $20,000  without  flinching,  if  called  upon  to  do  so  (no  assess¬ 
ments  have  been  made  for  twenty  years).  No  application  is  approved 
unless  the  concern  is  of  the  highest  commercial  standing  in  the  community. 
Our  inspection  department  is  a  most  important  adjunct  and  we  maintain  a 
corps  of  specially  trained  men  at  a  very  heavy  expense,  who  do  nothing  but 
inspect  our  risks  from  the  Atlantic  to  the  Pacific  four  times  a  year.  Our 
subscribers,  who  are  not  in  business  to  burn,  cheerfully  cooperate  with  our 
efforts  to  minimize  the  fire  hazard.” 

The  writer  went  to  a  subscriber  to  this  reciprocal  and  asked  him  if  he 
would  show  him  the  signatures  to  his  insurance  policy.  As  he  read  over  the 
names  of  America’s  leading  merchants,  he  realized  the  literal  truth  of  what 
the  attorneys  had  written  him  and  began  to  comprehend  how  it  has  been  pos¬ 
sible  for  this  group  during  twenty-five  years  to  have  a  loss  record  of  only 
$536,000  and  to  pay  back  to  its  members  a  total  of  $6,000,000  in  cash  refunds. 

The  advisory  committee ,  or  trustees. — The  advisory  committee  is  a  part 
of  every  reciprocal  organization.  In  some  cases  it  is  a  real  power,  though 
in  others  the  opponents  of  the  method  declare  the  members  of  the  committee 


3io 


RISK  AND  RISK-BEARING 


to  be  figureheads  utilized  by  profiteering  managers.  This  committee  is 
elected  by  the  subscribers  and  has  three,  five,  or  seven  members. 

Objections  to  reciprocal  insurance.— The  chief  objections  to  reciprocal 
insurance  have  been  summarized  by  John  F.  Ankerbauer1  who  has  been  one 
of  the  leaders  of  those  opposing  the  method.  They  are  as  follows: 

1.  Subscribers  do  not  understand  the  nature  of  their  obligations  under  the 
subscriber' s  agreement;  they  have  little  or  no  knowledge  of  the  obligations 
incurred  for  them  by  their  attorney-in-fact .  This  objection  can  be  met  by  the 
subscriber’s  studying  carefully  his  power  of  attorney,  his  articles  of  agree¬ 
ment,  and  the  reports  of  his  attorney  which  every  agreement  should  require 
at  frequent  intervals.  Such  study  should  lead  to  care  in  the  choice  of  a 
reciprocal. 

2.  Reserves  are  inadequate.  This  has  been  true  of  some  reciprocals.  It 
is  true  of  every  exchange  that  fails.  A  prospective  subscriber  should  shun 
a  reciprocal  unless  adequate  reserves  as  required  of  old-line  companies  are 
maintained.  He  should  make  sure  that  there  is  both  a  premium  reserve  and 
an  accumulated  surplus  as  a  provision  against  unusual  losses.  He  should 
also  find  out  whether  a  sound  policy  for  investing  reserves  such  as  is  com¬ 
pulsory  for  stock  companies  is  carefully  followed. 

3.  The  subscriber  does  not  know  the  identity  of  his  fellow-subscribers  who 
are  insuring  him.  Unfortunately  some  exchanges  are  doing  business  in 
such  a  fashion.  They  should  be  forced  to  change  their  method  by  lack  of 
business.  Nobody  should  think  of  taking  insurance  from  unknowns. 

4.  Some  exchanges  mix  the  business  of  separate  industries  when  the  insur¬ 
ance  by  groups  is  supposed  to  be  distinct.  If  steam  laundries,  bakeries,  and 
hotels  insure  each  other  at  the  same  exchange,  each  insuring  others  of  the 
same  industry  only,  it  is  a  misrepresentation  when  the  accounts  of  resources 
and  liabilities  are  not  kept  entirely  separate  and  so  reported. 

5.  If  the  attorney  does  not  settle  a  loss  satisfactorily ,  suit  has  to  be  brought 
against  too  many  persons  in  too  many  places.  Most  contracts  provide  that 
the  attorney  shall  accept  process,  permitting  all  suits  to  be  brought  in  one 
place.  The  prospect  of  legal  trouble  emphasizes  the  importance  of  dealing 
oniy  with  a  high-class  exchange  composed  of  manager  and  subscribers  of 
unquestioned  responsibility  and  integrity.  Legislation  for  reciprocal  insur¬ 
ance,  as  pointed  out  below,  attempts  to  simplify  the  matter  of  bringing  suits. 

6.  It  is  beyond  the  power  of  a  corporation  to  have  such  insurance  unless 
its  charter  gives  it  permission  to  engage  in  the  insurance  business;  if  such  par¬ 
ticipation  is  not  legal,  no  liability  can  accrue.  There  have  been  some  court 
decisions  supporting  this  view.  In  one  state  some  large  concerns  have 
withdrawn  from  reciprocal  exchanges  on  account  of  the  advice  of  counsel 
that  the  above  objection  is  well  taken. 

1  Inter -insurance  Information ,  32  pages.  (Cincinnati:  John  F.  Ankerbauer. 
Not  dated.) 


FIRE  INSURANCE 


3ii 

Since  authorities  differ  it  becomes  necessary  in  each  state  to  discover 
the  weight  of  opinion  and  act  accordingly.  The  uniform  reciprocal  law 
which  has  been  adopted  in  so  many  states  clears  up  this  problem  by  provid¬ 
ing  expressly:  “Any  corporation  now  or  hereafter  organized  shall,  in  addi¬ 
tion  to  the  rights,  powers  and  franchises  specified  in  its  articles  of  incorpora¬ 
tion,  have  full  authority  and  power  as  a  subscriber  to  exchange  insurance 
contracts  of  the  kind  and  character  herein  mentioned.  The  right  to 
exchange  such  contracts  is  hereby  declared  to  be  incidental  to  the  purposes 
for  which  such  corporations  are  organized,  and  as  fully  granted  as  the  rights 
and  powers  expressly  conferred  upon  the  corporation.”1  It  is  said  that  the 
constitutionality  of  such  a  blanket  addition  to  charters  of  all  corporations 
will  be  attacked. 

7.  Just  as  serious,  in  some  states,  as  objection  number  6  has  been  the 
view  of  some  state  insurance  departments  that  inter -insurance  without  a 
license  from  the  state  department  is  contrary  to  law. 

Before  the  passage  of  the  reciprocal  insurance  law  by  Virginia  in  1918 
agents  in  that  state  were  subject  to  arrest.  Persons  who  wished  such  insur¬ 
ance  went  to  New  York,  Chicago,  St.  Louis,  or  Kansas  City,  Missouri,  for 
it,  and  became  parties  to  agreements  with  firms  and  corporations  not  resi¬ 
dent  in  Virginia.  This  practice  was  so  general  in  states  not  providing  by 
law  for  reciprocal  insurance,  that  a  manager  of  a  western  exchange  said  that 
he  expected  to  write  little  more  insurance  in  a  certain  state  after  the  law  was 
passed  than  he  had  been  writing  before  its  passage. 

8.  A  reciprocal  insurance  agreement  forms  a  partnership;  liability  cannot 
be  restricted  by  contract ,  and  each  subscriber  may  be  liable  for  the  entire  face  of 
the  policy.  This  objection  seems  doomed,  certainly  in  states  where  such 
insurance  is  provided  for  by  statute,  and  in  any  other  state  where  such  a 
contract  is  not  repugnant  to  its  constitution  or  statutes.  There  seems  no 
doubt  of  the  limited  liability  if  the  attorney  signs  each  policy  separately  for 
each  subscriber,  and  specifies  that  the  liability  is  several  and  not  joint.  If 
every  subscriber  has  made  the  same  kind  of  usual  agreement,  there  is  no 
partnership.  Every  subscriber  possesses  that  agreement  in  duplicate,  or 
has  seen  it,  so  there  are  no  innocent  third  parties. 

9.  The  attorney-in-fact  has  too  much  intrusted  to  him;  he  is  an  autocrat. 
There  is  great  danger  here.  To  safeguard  against  an  incompetent  or  a  dis¬ 
honest  manager,  a  strong  advisory  committee  or  board  of  trustees  must  be 
provided.  Unsafe  underwriting  and  insufficient  inspection  are  to  be  guarded 
against.  In  practically  every  case  the  manager’s  compensation  comes  from 
a  percentage  of  premiums.  He  is  tempted  to  assume  risks  that  are  less 
good  and  to  give  the  applicant  the  benefit  of  the  doubt.  He  is  less  likely 
to  yield  if  he  realizes  that,  as  losses  increase,  subscribers  diminish;  but  the 

1  Section  9,  Ohio  House  Bill  No.  325,  82  General  Assembly,  Regular  Session, 
1917. 


312 


RISK  AND  RISK-BEARING 


best  restraining  influence  is  to  subject  him  to  the  control  of  the  subscribers 
acting  through  a  committee. 

io.  The  advisory  committee  does  nothing;  it  trusts  the  attorney.  Unless 
the  committee  is  annually  elected  by  the  subscribers,  given  authority  over 
the  managers,  and  paid  for  their  services,  this  is  a  real  objection.  While  a 
competent  manager  must  have  a  free  hand,  certain  exchanges  have  trustees 
who  really  act  as  a  board  of  directors.  Within  the  past  year  the  manager 
of  one  exchange  was  retired. 

Advantages  of  inter -insurance. — The  advantages  that  are  claimed  for 
reciprocal  insurance  are  as  follows: 

1.  The  expenses  of  operation  are  less,  due  to  dealing  with  a  particular 
class  of  risks,  permitting  specialized  service,  and  the  reduction  of  local  commis¬ 
sions  to  a  minimum  Many  exchanges  have  no  local  commissions  to  pay. 
Some  exchanges  operate  at  a  low  cost,  but  there  are  others  that  have  saved 
little  or  nothing  for  their  subscribers. 

2.  All  hut  high-class  risks  are  eluninated.  This  is  true  for  some  exchanges 
and  untrue  for  others. 

3.  Frequent  inspections  by  trained  inspectors.  This  is  a  great  advantage 
of  some  of  the  exchanges.  There  are  others  that  do  very  little  along  this 
line. 

4.  Consolidation  of  small  policies  into  a  large  one.  Many  companies 
will  not  write  more  than  a  small  part  of  the  insurance  of  a  large  concern. 
The  insurance  obtainable  by  the  reciprocal  method  in  one  policy  runs  all  the 
way  from  a  small  amount  up  to  over  one  million  dollars. 

5.  The  probable  large  saving.  Some  people  have  not  saved  anything; 
others  save  25  per  cent  to  85  per  cent  of  their  premiums. 

Legislation. — The  sweep  of  legislation  to  favor  reciprocal  insurance  and 
to  control  it  indicates  that  the  states  recognize  both  the  strength  of  the 
reciprocal  method  and  the  dangers  of  its  misuse.  The  main  features  of  such 
legislation  are:  (1)  to  require  reciprocals  to  file  copies  of  their  agreement. 
powrers  of  attorney,  and  contracts;  (2)  to  make  complete  reports  of  their 
condition  to  the  department  of  insurance;  (3)  to  compel  the  maintenance 
of  premium  reserves,  a  minimum  amount  of  business,  and  the  possession 
at  all  times  of  such  an  amount  of  quick  assets  as  to  make  certain  their  ability 
to  settle  at  once  a  heavy  loss;  (4)  to  enable  a  suit  to  be  brought  by  a  claim¬ 
ant  in  his  own  county  against  the  attorney,  or  any,  or  all  of  the  subscribers 
by  serving  process  upon  the  state  insurance  commissioner  who  s  declared 
to  be  the  representative  for  that  purpose  of  the  attorney  and  each  of  his  sub¬ 
scribers;  and  (6)  to  tax  the  business  of  reciprocals  as  other  insurance  is  taxed. 

Conclusions. — A  study  of  the  methods,  advantages  and  disadvantages 
of  reciprocal  fire  insurance  leads  one  to  conclude  that  the  principle  is  sound, 
but  that  such  insurance  is  neither  incompetence-proof  nor  crook-proof. 
In  theory  the  attorney-manager  is  the  agent  of  his  principal,  the  subscriber. 


FIRE  INSURANCE 


313 


That  is  proving  to  be  the  soundest  practice.  The  attorney  ought  to  be 
subject  to  control  by  the  subscribers.  Just  as  directors  are  a  real  force  in 
the  management  of  a  bank  or  insurance  company,  so  the  advisory  committee 
ought  to  be  in  a  position,  if  need  be,  to  assert  its  authority  over  the  attorney. 
It  seems  contrary  to  good  principle  for  an  agreement  to  read  as  one  did: 
“Neither  the  subscriber  or  subscribers,  has,  have,  or  shall  have,  any  owner¬ 
ship  or  property  interest  in  or  to  the  business,  plan  of  business,  system  of 
indemnity  insurance,  office  or  office  property  of  the  attorney-in-fact,  or  any 
property  right  in  or  to  said  exchange.”  The  manager  must  be  a  successful 
underwriter  and  a  man  above  reproach,  committed  to  the  welfare  of  his 
principals,  rather  than  a  self-seeking  adventurer.  All  but  high-class  risks 
must  be  eliminated,  and  rigid,  frequent  inspection  must  be  enforced.  For 
people  who  intend  to  adopt  every  means  of  preventing  fire,  who  themselves 
constitute  no  moral  hazard,  whose  commercial  integrity  is  the  highest,  whose 
several  properties  are  widely  scattered,  but  whose  interests  draw  them  so 
closely  together  that  they  have  knowledge  of  each  other’s  integrity,  there  is 
a  profitable  field  for  reciprocal  insurance.  For  other  people  the  range  of 
liability  is  so  great  that  the  value  of  the  plan  is  doubtful.  The  business 
man  must  proceed  as  carefully  in  its  use  as  if  he  were  buying  stock  in  a  corpora- 
tion  or  extending  a  line  of  credit.  Instead  of  getting  insurance  he  may  increase 
his  liabilities.  Rockefeller’s  success  in  oil  does  not  foreordain  the  success 
of  every  oil  project.1 

V.  RATES  AND  RATE-MAKING 

The  rate  in  fire  insurance  is  quoted  as  the  number  of  cents  per 
annum  per  hundred  dollars  insurance.  Considerably  lower  rates 
are  granted  on  three-  or  five-year  contracts,  in  some  cases  five  years’ 
insurance  being  sold  for  as  little  as  three  times  the  annual  premium, 
while  on  the  other  hand  the  “short  rate”  for  less  than  one  year’s 
insurance  is  much  higher  than  the  annual  rate.  The  practice  of 
extending  much  lower  rates  for  long  than  for  short  contracts  is  due 
to  several  causes.  The  burning  rate  is  somewhat  higher  during 
the  earlier  period  of  the  life  of  the  average  policy,  presumably  on 
account  of  greater  moral  hazard;  the  selling  costs  are  less  on  long¬ 
term  than  on  short-term  policies,  and  the  office  expenses  connected 
with  the  issuance  of  the  policy  are  of  course  proportionately  much 
greater  on  short  contracts;  the  excess  premium  on  a  long  contract 
is  a  clear  gain  in  case  a  total  loss  occurs  in  the  earlier  period;  and 
the  danger  of  losing  a  given  piece  of  business  to  a  competitor  grows 
less  as  the  term  of  the  contract  increases. 

1  Adapted  by  permission  from  J.  Anderson  Fitzgerald,  “Reciprocal  or  Inter- 
Insurance  against  Loss  by  Fire,”  American  Economic  Review ,  X  (March,  1920). 
92-103. 


RISK  AND  RISK-BEARING 


314 

The  determination  of  the  proper  level  of  insurance  rates,  as  a 
whole,  is  not  an  extremely  difficult  problem,  but  the  proper  apportion¬ 
ment  of  the  burden  is  a  source  of  great  perplexity  and  controversy. 
The  problem  is  not  dissimilar  to  that  which  arises  in  connection  with 
freight  rates,  where  the  determination  of  the  amount  necessary  to 
maintain  service  and  provide  a  fair  return  on  capital  is  simple  com¬ 
pared  to  the  problem  of  distributing  this  cost  to  the  various  kinds  of 
service  rendered.  In  fire  insurance,  the  difficulty  arises  from  the 
irregularity  of  the  incidence  of  fire  loss  from  year  to  year,  and  from 
the  extreme  complexity  of  the  factors  which  make  one  individual  risk 
greater  than  another.  The  total  income  of  the  insurance  company, 
if  the  business  is  to  continue,  must  be  great  enough  to  provide  for 
normal  losses,  the  expenses  of  carrying  on  the  business,  a  contribution 
to  a  conflagration  reserve,  the  proper  size  of  which  is  a  matter  of 
conjecture,  and  a  fair  return  on  the  invested  capital.  As  the  bulk 
of  the  invested  capital  is  in  the  form  of  income-bearing  securities, 
however,  the  necessary  return  to  capital  from  the  insurance  operations 
is  quite  Small.  Aside  from  the  small  fixed  assets  and  the  money  used 
up  in  organization  expenses,  the  capital  pays  its  own  way,  except  for 
the  return  necessary  to  compensate  investors  for  exposing  their 
capital  to  the  hazard  of  loss  through  conflagration.  In  many  years 
the  underwriting  profit  is  quite  small,  but  over  a  period  of  years  the 
business  has  proved  very  profitable  for  the  majority  of  those  engaged 
in  it.  When  returns  are  stated  as  a  percentage  on  capital,  the  busi¬ 
ness  appears  more  profitable  than  it  really  is,  because  of  the  large 
amount  of  invested  capital  which  is  carried  as  surplus.  Much  of 
this  is  the  result  of  the  accumulation  of  past  profits,  but  quite  com¬ 
monly  part  of  the  surplus  represents  capital  obtained  by  selling  stock 
at  a  premium,  a  practice  necessitated  by  the  laws  of  certain  states 
which  require  the  entire  capital  stock  to  be  held  in  securities  of  a 
specified  character. 

The  adjustment  of  the  rate  to  the  individual  hazard  is  much 
more  difficult  in  fire  than  in  life  insurance,  because  so  much  gi eater 
effort  is  made  to  take  account  of  factors  which  cause  variation  in  the 
degree  of  risk.  Whereas  in  life  insurance  it  is  practicable  to  draw  a 
line  between  the  insurable  and  the  uninsurable,  and  then  subdivide 
the  insurable  into  groups  according  to  age  alone,  in  fire  insurance  the 
rate  on  certain  types  of  property  is  adjusted  to  take  account  of  several 
hundred  different  elements  of  variation  in  the  risk.  The  resulting 
groups  of  risks  which  are  alike  in  all  respects  are  too  small  to  permit 


FIRE  INSURANCE 


3J5 


statistical  justification  of  any  rate  for  each  group  separately.  The 
variations  in  rates  on  different  kinds  of  property  are  expressions  of 
the  judgment  of  experienced  underwriters  as  to  the  effect  which  a 
given  difference  in  construction,  occupancy,  exposure,  or  protection 
ought  logically  to  exert  upon  the  loss  ratio.  Each  company  is  con¬ 
stantly  studying  its  experience  to  secure  a  better  basis  for  rate¬ 
making,  but  little  has  been  done  toward  making  their  accumulated 
experience  common  property,  and  until  much  more  detail  has  been 
made  public,  concerning  the  actual  experience  with  different  types 
of  risk,  fire  insurance  rates  will  remain  under  the  suspicion  of  arbi¬ 
trariness. 

In  most  parts  of  the  United  States,  rates  are  made  by  associations 
of  insurers,  which  serve  the  double  purpose  of  effecting  an  economy  in 
the  work  of  inspecting  properties,  constructing  fire  maps,  computing 
rates,  etc.,  and  of  eliminating  any  tendency  toward  cut-throat  com¬ 
petition.  The  rates  made  by  these  associations  are  subject  to  a 
limited  amount  of  supervision  by  the  insurance  authorities  of  the 
various  states,  some  states  requiring  merely  the  filing  of  rates,  others 
intrusting  to  their  commissioners  extensive  powers  of  revision.  In  a 
few  states,  the  full  power  of  making  rates  is  lodged  by  law  in  the  state 
authorities. 

In  adjusting  the  rates  on  individual  risks,  two  methods  are  in  use. 
In  the  case  of  farm  buildings,  dwellings,  churches,  and  a  number  of 
other  classes  of  building,  where  the  difference  in  individual  hazard 
is  not  great,  the  principle  of  classification  is  employed.  Under  this 
plan,  risks  are  thrown  together  into  a  few  classes  which  are  roughly 
alike,  and  one  rate  is  applied  to  the  entire  class,  subject  to  a  modifica¬ 
tion  in  the  case  of  city  property  based  on  a  rating  given  to  the  city. 
For  instance,  all  three-story  brick  apartments  in  a  given  city  may  be 
given  one  rating ;  all  frame  dwellings  another  rating;  all  brick  churches 
another;  and  so  on.  The  second  method,  which  is  generally  applied 
to  mercantile  and  industrial  property,  is  known  as  schedule  rating. 
Under  this  system,  no  attempt  is  made  to  group  together  all  risks 
entitled  to  the  same  rate.  Instead,  the  rate  is  built  up  by  establishing 
an  arbitrary  starting-point  in  a  given  combination  of  features  of 
hazard,  then  drawing  up  a  detailed  schedule  of  additions  and  deduc¬ 
tions  from  a  basis  rate  which  is  assumed  to  be  applicable  to  this 
standard.  Manufacturing  risks  are  rated  under  a  great  variety  of 
special  schedules,  while  mercantile  properties  are  generally  rated 
under  some  modification  of  one  of  two  systems,  the  Universal  Mer- 


3l6 


RISK  AND  RISK-BEARING 


cantile  Schedule,  which  is  widely  used  in  the  East,  and  the  Dean 
Schedule,  which  is  universal  in  the  West. 

The  Universal  Mercantile  Schedule  starts  by  defining  a  standard 
building  and  a  standard  city,  and  fixes  a  basis  rate  of  twenty -five 
cents  for  the  combination  of  these  two  standards.  Next,  the  rate 
for  the  individual  city  is  determined  by  adding  specific  amounts  to 
the  twenty-five-cent  rate  for  specific  deficiencies,  such  as  narrow 
streets,  inadequate  police  service,  extensive  lumber  districts,  etc.,  and 
making  deductions  for  unusually  favorable  features.  Then  by  a 
similar  schedule  of  additions  and  deductions,  the  rate  for  the  standard 
building  in  the  given  city  is  converted  into  the  rate  for  the  given 
building.  Successive  modifications  are  then  made  for  the  character 
of  the  occupancy,  the  individual  fire  protection,  the  exposure,  and 
the  presence  or  absence  of  coinsurance.  The  rate  on  the  contents 
is  built  up  in  a  similarly  complicated  manner  from  the  rate  on  the 
building,  additions  and  deductions  taking  care  of  both  the  special 
features  of  hazard  connected  with  the  building  and  those  arising  from 
the  character  of  the  contents  themselves.  The  following  account  of 
the  rating  of  a  manufacturing  building  gives  a  good  idea  of  the  way 
in  which  schedule  rates  are  constructed: 

This  particular  building  has  been  inspected  and  surveyed  by  the  rater. 
The  degree  of  municipal  and  local  protection  has  been  measured.  This 
establishes  the  basis  rate  of  .40  which  is  a  charge  commensurate  with  the 
degree  of  protection  and  covers  all  general  hazards  that  cannot  be  segre¬ 
gated  and  measured.  In  passing,  let  it  be  noted  that  the  better  the  city 


protection  the  lower  will  be  the  basis  rate. 

The  rate  is  established  as  follows: 

Basis  rate.  . . . . 40 

Area  15,800  sq.  ft . 04 

(The  standard  unit  area  is  1 ,000  sq.  ft.,  a  proportionate 
additional  charge  being  made  for  larger  areas.) 

Parapet  deficiency . . . .04 

Skylights  not  standard . 02 

Metal  stacks  through  roof . . . . 06 

Outside  wood  porches,  cornices  and  wooden  conveyor.  .  .06 

Gallery  decks . . .  . .  . . . . .  .03 

Occupancy . \  . . .  .92 

Shavings  allowed  to  accumulate . . 05 

No  waste  cans .  *  . . „ . . 05 

Floor  oil  soaked .  05 

No  drip  pans  under  machines  . 05 

Total.  1.77 

Credit  for  open  finish . . . . . 08 


Building  rate  unexposed . .  1.69 


FIRE  INSURANCE 


317 


Exposure 

From  buildings  No.  2  and  No.  5  at  18  ft . 34 

From  building  No.  6  at  15  ft . . . 02 

From  office  at  23  ft . . 05 

From  buildings  No.  9  and  No.  10 . 07 

Exposure  charge . 48 

Total  building  rate .  2.17 


The  occupancy  charge  of  92  cents  in  the  foregoing  table  is  made  up  as 


follows: 

Grinding,  machine  shop,  and  blacksmith  shop . 06 

Gas  tempering  furnace . 01 

1  brick  forge  and  1  movable  forge . 01 

3  crude  oil  furnaces . 02 

High  pressure  steam  boiler  using  shavings  partly  as  fuel 
and  coal  with  an  unapproved  arrangement  for  shavings 

in  brick  room . 26 

Inadequate  ventilation . 04 

Gasoline  automobile  in  building . 12 

Woodworking  (1  pony  planer,  1  rip  saw,  1  cross  cut).. .  .10 

Wire  room  (2  auto,  wire  knotters,  4  wire  cutters  and 

straighteners — all  on  wood  using  oil) . 24 

10  hand  knotting  machines,  additional  labor,  28  hands.  .06 

Total  occupancy  charge . 92 


With  this  detailed  information  in  the  hands  of  the  business  man  he 
can  figure  exactly  how  to  reduce  his  fire  insurance  rate  and  what  the  cost 
of  the  changes  will  be. 

Assuming  that  he  carries  a  line  of  $65,000  on  this  building  his  annual 
premium  is  $1,410.50.  For  each  .01  reduction  in  the  rate  he  is  saving 
$6.50  every  year. 

He  finds  that  he  can  bring  the  parapet  wall  up  to  the  standard  require¬ 
ment  for  $30.00.  By  this  expenditure  he  lessens  the  hazard  and  reduces 
the  rate  .04,  thus  saving  in  premiums  $26.00  each  year.  He  has  the  shavings 
removed  daily,  installs  waste  cans,  and  drip  pans  under  the  machines  at  a 
small  expense.  These  improvements  reduce  the  rate  .15.  He  finds  that 
his  automobile  being  stored  in  the  building  is  costing  him  $78.00  a  year  in 
increased  premium.  He  puts  the  car  in  a  small  garage  and  reduces  the 
rate  .12. 

By  comparing  what  the  hazards  are  costing  him  with  the  expense  of 
correcting  them  he  determines  how  much  he  deems  it  advisable  to  reduce 
his  own  rate.  As  a  matter  of  fact,  the  owner  makes  his  own  rate — the  rater 
simply  measures  the  hazards  in  terms  of  rates. 

The  rate  of  $2.17  was  reduced  to  $1.86  by  a  comparatively  small  out¬ 
lay  of  money.  In  addition  the  liability  to  fire  has  been  reduced.  This 
should  be  a  stronger  incentive  than  the  saving  of  insurance  premiums.1 


‘Taken  by  permission  from  John  J.  Thomas,  What  the  Business  Man  Should 
Know  About  Fire  Insurance ,  pp.  12-13.  (Chicago,  1922.) 


RISK  AND  RISK-BEARING 


318 


The  Dean  Schedule  presents  several  points  of  contrast  to  the 
Universal  Mercantile  Schedule.  The  starting-point  under  this 
system  is  a  one-story  brick  building  of  ordinary  construction,  in  a 
town  of  the  sixth,  the  lowest,  class.  No  rate  is  prescribed  for  this 
standard  risk,  the  system  being  so  constructed  as  to  be  applicable  to 
any  base  rate  which  the  rating  bureau  may  consider  applicable  to 
the  community.  The  additions  and  deductions,  which  adapt  the 
rate  to  the  special  features  of  the  individual  hazard,  are  made  in  the 
form  of  percentages  instead  of  flat  charges.  The  theorv  under¬ 
lying  this  system  is  that  a  given  defect  of  construction  or  protection 
is  more  serious  in  a  building  which  is  otherwise  a  poor  risk  than 
in  the  case  of  a  building  otherwise  relatively  safe.  The  system  also 
provides  a  much  more  careful  analysis  of  occupancy  and  exposure 
hazards  than  is  attempted  in  the  Universal  Schedule. 

Upon  the  whole,  the  schedule  rates  seem  to  be  more  equitable 
than  the  classified  rates,  perhaps,  however,  because  our  knowledge 
of  the  actual  fire  losses  with  different  combinations  of  the  elements 
of  risk  is  not  sufficient  to  expose  the  shortcomings  of  the  schedules. 
As  is  to  be  expected  in  a  task  of  such  complexity,  it  is  impossible  to 
secure  a  schedule  which  commends  itself  in  all  details  to  the  judg¬ 
ment  of  any  one  critic,  and  persons  disposed  to  do  so  have  no  difficulty 
in  finding  rather  obvious  flaws  in  the  rating  system.  Until  statistics 
are  available,  however,  for  determining  the  loss  experience  on  a  large 
number  of  classes  of  risk,  we  shall  be  obliged  to  content  ourselves  with 
the  sort  of  imperfection  which  the  current  schedules  exhibit.  The 
most  serious  criticism  is  not  the  occasional  absurdity  in  the  relative 
rates  for  given  risks,  but  the  tendency  for  certain  rates  to  be  warped 
by  the  conditions  surrounding  the  selling  of  insurance,  conditions 
which,  as  a  rule,  work  to  the  disadvantage  of  owners  of  property 
which  falls  within  the  classified  groups.  Manufacturers  and  mer¬ 
chants  scrutinize  their  insurance  bills  carefully  and  chambers  of 
commerce  and  manufacturers’  associations  are  effective  means  of 
protest  against  rates  deemed  too  high.  Purchasers  of  insurance  on 
dwellings,  school  buildings,  and  churches,  on  the  other  hand,  are  less 
effectively  organized  and  are  apt  to  regard  their  insurance  as  an  item 
of  expense  too  small  to  be  worth  quibbling  over,  which  indeed  it 
often  is.  So  conspicuous  has  the  resulting  shift  of  the  burden  from 
certain  types  of  property  become,  that  insurance  companies  have 
created  an  informal  classification  of  properties  into  preferred  and 
ordinary  risks,  the  term  “preferred  risk”  denoting,  not  a  property 


FIRE  INSURANCE 


319 


where  the  burning  rate  is  low,  but  a  property  where  the  insurance 
rate  is  high. 

If  rates  were  adjusted  accurately  in  accordance  with  the  consensus 
of  insurance  opinion  as  to  the  hazards  involved,  even  though  that 
opinion  might  involve  a  large  degree  of  approximation,  there  would 
be  no  such  thing  as  a  preferred  risk;  one  risk  would  offer  as  much 
prospect  of  profit  as  another.  The  notorious  preference  of  insurers 
for  certain  classes  of  business  is  sufficient  evidence  of  the  inadequacy 
of  present  methods  of  apportioning  the  burden  of  insurance. 


CHAPTER  XV 


MISCELLANEOUS  PROPERTY  INSURANCE 

Aside  from  contracts  of  life  and  fire  insurance,  there  are  innumer¬ 
able  similar  arrangements  by  which  the  risks  of  business  are  eliminated 
or  reduced,  through  transfer  to  specialists  and  consequent  combination 
of  risks  or  prevention  of  the  event  insured  against.  In  general,  almost 
any  risk  is  insurable,  and  will  be  insured  by  casualty  companies  if  the 
following  conditions  are  present:  (a)  a  body  of  experience  sufficient 
to  afford  a  basis  of  judgment  concerning  the  probable  loss  ratio;  ( b ) 
a  loss  ratio  low  enough  so  that  rates  need  not  be  prohibitively  high; 

(c)  a  probability  of  individual  losses  large  enough  to  make  it  worth 
while  for  individuals  to  take  the  precaution  of  insuring  against  them; 

(d)  a  loss  ratio  high  enough  so  that  individuals  are  alive  to  the  hazard 
and  can  be  induced  without  excessive  selling  cost  to  provide  against 
it;  (e)  independence  of  the  separate  risks,  so  that  the  company  can 
secure  a  fair  distribution  of  the  hazard ;  (/)  freedom  of  the  event  insured 
against  from  complete  control  by  the  insured. 

Of  these  many  types  of  insurance,  few  present  special  features  of 
interest  sufficient  to  warrant  detailed  study  in  a  general  survey  of 
methods  of  dealing  with  risk.  The  risks  of  labor  and  the  insurance 
devices  for  taking  care  of  financial  risks  associated  with  the  labor  con¬ 
tract  will  be  considered  in  chapter  xvii;  other  types  of  insurance 
include  the  following: 

Marine  insurance  comprises  the  whole  field  of  insurance  against 
risks  arising  from  the  transportation  of  goods,  and  falls  into  two  main 
branches:  ocean  marine,  which  is  what  is  ordinarily  referred  to  as 
marine  insurance,  and  inland  marine,  which  includes  such  forms  of 
protection  as  transportation,  tourist  baggage,  parcel  post,  registered 
mail,  and  motor  truck  contents  insurance. 

Ocean  marine  insurance  is  the  oldest  form  of  indemnity,  of  which 
there  is  any  record,  and  the  policy  usually  written  retains  evidence  of 
its  age  in  the  quaintness  of  its  wording.  The  perils  insured  against 
are: 

Of  the  seas,  men-of-war,  fire,  enemies,  pirates,  rovers,  thieves,  jettisons, 
letters  of  mart  and  countermart,  surprisals,  takings  at  sea,  arrests,  restraints, 
and  detainments  of  all  kings,  princes  and  people,  of  what  nation,  condition, 


320 


MISCELLANEOUS  PROPERTY  INSURANCE 


321 


or  quality  soever,  barratry  of  the  master  and  mariners,  and  of  all  other  perils, 
losses,  and  misfortunes  that  have  or  shall  come  to  the  hurt,  detriment  or 
damage  of  the  said  goods  and  merchandises  and  ship,  etc.,  or  any  part 
thereof. 

Omitting  reference  to  the  items  which  enumerate  hazards  of  war, 
the  clauses  enumerating  the  hazards  may  be  explained  as  follows: 
“  Perils  of  the  seas,”  refers  to  damage  from  storm,  collision,  ice,  strand¬ 
ing,  and  such  excessive  action  of  the  wind  and  waves  as  is  not  antici¬ 
pated  in  the  ordinary  course  of  navigation.  The  line  between  ordi¬ 
nary  wear  and  tear  and  damage  by  storm  is  sometimes  hard  to  draw, 
but  the  principle  involved  is  that  the  policy  shall  insure  against  losses 
which  may  happen,  not  those  which  must  happen.  “Pirates,  robbers, 
and  assailing  thieves,”  include  all  outside  sources  of  loss  through  theft, 
and  “barratry”  covers  various  unlawful  acts  of  master  and  crew 
(including  mutiny,  diversion  of  the  ship  from  its  course,  scuttling,  and 
open  robbery  by  the  crew),  but  neither  clause  covers  pilferage  by  the 
ship’s  company.  “Jettison”  means  the  throwing  overboard  of  part 
of  the  vessel’s  cargo  for  the  purpose  of  relieving  the  ship  in  distress. 

The  interpretation  of  an  ocean  marine  policy  is  extremely  technical, 
as  is  indeed  the  whole  of  admiralty  law,  and  into  the  intricacies  of  the 
policy  it  is  unnecessary  for  us  to  go.  A  few  outstanding  peculiarities 
of  this  type  of  insurance,  however,  may  be  mentioned.  In  contrast 
to  fire  insurance,  the  ocean  marine  policy  is,  in  a  great  majority  of 
cases,  a  valued  policy.1  Another  contrast  with  fire  insurance  is  the 
fact  that  under  certain  conditions  a  marine  policy  may  be  valid,  even 
though  at  the  time  it  was  taken  out  the  insured  had  no  insurable 
interest  in  the  property.  This  is  the  case  where  the  property  had 
already  been  destroyed,  but  the  facts  were  not  known  either  to  the 
insurer  or  the  insured.  This  is  taken  care  of  by  the  phrase  “lost  or 
not  lost,”  included  in  the  description  of  the  property  insured. 

A  third  contrast  with  the  usual  practice  in  fire  insurance  is  the 
rule  with  regard  to  constructive  total  loss.  A  constructive  total 
loss  occurs  when  the  property  insured  is  not  physically  destroyed,  but 
is  so  situated  that  the  cost  of  rescue  or  repair  would  be  greater  than 
the  value  of  the  property.  Notice  of  intent  to  claim  a  constructive 
total  loss  is  given  through  “notice  of  abandonment,”  an  offer  on  the 
part  of  the  insured  to  abandon  the  property  to  the  insurer  in  return 
for  payment  of  the  face  of  the  policy.  Such  notice  does  not  obligate 
the  insurer  to  accept  abandonment,  nor  does  it  release  the  owner  from 

1  See  p.  293. 


322 


RISK  AND  RISK-BEARING 


the  obligation  to  exercise  reasonable  care  to  preserve  whatever  value 
may  remain;  it  merely  evidences  good  faith  in  claiming  a  constructive 
total  loss. 

A  very  wide  range  of  special  clauses  and  special  types  of  policy  is 
offered.  “ Voyage''’  policies  cover  a  definitely  described  voyage; 
“time”  policies  cover  vessels  for  a  stated  period.  “Fleet”  insurance 
covers  a  large  group  of  vessels  by  a  blanket  policy.  “Builders’  risk” 
policies  provide  protection  during  the  construction  or  repair  of  vessels. 
Cargoes  may  be  protected  by  “named”  policies,  which  designate 
the  vessel  to  be  used,  by  “floating”  policies,  which  designate  merely 
the  voyage  and  type  of  vessel,  or  by  “open”  policies  which  cover  all 
the  shipments  made  by  a  given  firm  within  the  life  of  the  policy. 

The  rates  in  marine  insurance  are  highly  unstandardized,  competi¬ 
tive,  and  unstable.  There  is  no  such  thing  as  schedule  rating.  There 
is  a  very  limited  body  of  statistical  data  from  which  to  estimate  the 
risk,  and  such  facts  as  have  been  gathered  are  closely  guarded  by  the 
individual  companies  as  trade  information.  Moreover,  the  moral 
hazard  is  very  great,  and  even  in  the  absence  of  fraud  or  deliberate 
carelessness  the  loss  experience  of  different  operators  varies  widely. 
Consequently,  the  element  of  judgment  enters  to  a  greater  extent  than 
into  almost  any  other  type  of  insurance. 

Tornado  insurance  is  written  in  connection  with  fire  insurance, 
and  is  very  popular  in  sections  of  the  country  which  are  subject  to 
disastrous  wind  storms.  The  general  provisions  are  similar  to  those 
of  the  standard  fire  insurance  policy,  but  the  contract  is  simpler  for 
the  reason  that  there  is  no  moral  hazard,  and  no  need  of  special  pro¬ 
vision  to  secure  proper  protective  measures  on  the  part  of  the  owner 
or  tenant.  Coinsurance  is  commonly  required,  where  state  laws  per¬ 
mit,  as  the  proportion  of  partial  losses  is  extremely  high. 

This  type  of  insurance  should  always  be  written  by  a  large  stock 
company  covering  a  very  wide  territory.  Local  mutuals  are  in  an 
especially  weak  position  with  regard  to  this  sort  of  coverage,  for  a 
severe  storm  may  cause  partial  loss  on  nearly  every  property  in  its 
path,  with  numerous  cases  of  total  loss;  an  insurer  must  have  a  very 
large  field  of  business  in  order  to  secure  an  adequate  distribution  of 
risks. 

Automobile  insurance. — The  rapid  increase  in  the  use  of  the  auto¬ 
mobile,  tor  purposes  both  of  business  and  pleasure,  has  created  a 
demand  for  this  new  type  ol  insurance.  About  30  per  cent  of  the 


MISCELLANEOUS  PROPERTY  INSURANCE 


323 


automobiles  in  the  United  States,  it  is  estimated,  are  covered  by  one 
or  more  of  the  standard  types  of  policy,  of  which  the  most  important 
are  the  following:  {a)  Liability  insurance;  this  policy  protects  the  in¬ 
sured  against  legal  liability  and  damages  because  of  personal  injury  to 
others  arising  out  of  the  use  of  an  automobile.  ( b )  Property  damage 
policies  protect  against  injury  to  the  property  of  others  which  may 
result  from  accidents  in  connection  with  the  use  or  ownership  of  an 
automobile,  (c)  Collision  insurance  protects  against  injury  to  the  car 
owned  by  the  insured,  resulting  from  collision  with  other  cars  or  with 
any  other  object.  ( d )  Fire  insurance  policies  are  very  similar  to  those 
written  on  buildings  and  other  property,  as  described  in  chapter  xiv. 
( e )  Theft  insurance  protects  against  loss  of  the  car,  or  of  its  parts  or 
accessories. 

In  these  types  of  insurance,  there  is  a  wide  difference  in  the  rates 
charged  in  different  territories,  on  different  types  of  cars,  and  under 
different  conditions  of  use.  For  instance,  the  rate  for  public  liability 
insurance  on  a  certain  car  ranges  from  $103  in  the  district  rated  highest 
to  $19  in  the  district  rated  lowest;  theft  insurance  in  one  territory 
ranges  from  $6.35  per  $100  on  one  car  to  $25  on  another.1 

Crop  insurance  is  a  highly  speculative  type,  because  of  the  extent 
to  which  losses  are  likely  to  be  coincident  for  a  large  number  of  policy¬ 
holders;  the  insurer  finds  it  difficult  to  secure  a  proper  distribution 
of  the  risk.  Moreover,  in  the  present  organization  of  the  business 
there  is  a  considerable  moral  hazard.  The  best  established  form  is 
hail  insurance,  which  has  been  of  considerable  importance  for  the 
past  twelve  or  fifteen  years.  The  total  premiums  paid  for  hail  insur¬ 
ance  in  1919  amounted  to  $30,000,000;  the  total  insurance  in  force 

\ 

to  $560,000,000. 

General  crop  insurance  has  been  attempted  in  only  a  few  instances. 
During  the  war  there  were  a  number  of  cases  of  price  insurance  in  New 
England,  but  these  were  effected  through  associations  of  public-spirited 
citizens  as  a  means  of  encouraging  increased  agricultural  production, 
and  not  as  a  business  carried  on  for  profit. 

In  1917,  three  insurance  companies  operating  in  the  northwest 
offered  insurance  against  crop  failure.  This  experiment  turned  out 
badly  for  the  insurers  on  account  of  drouth  and  failure  to  provide 
properly  against  the  assumption  of  risk  after  damage  had  already  taken 
place. 

1  Riegel  and  Loman,  Principles  of  Insurance ,  chap.  xx. 


324 


RISK  AND  RISK-BEARING 


In  1920,  two  companies  again  offered  crop  insurance— one  of 
them  including  in  its  coverage  protection  against  loss  due  to  decline 
in  the  market  value  of  the  crop,  an  experiment  which  proved  very 
costly  on  account  of  the  slump  in  grain  prices  of  that  year.  Various 
forms  of  protection  are  now  offered  in  limited  territories,  but  this 
form  of  insurance  is  still  in  its  experimental  stage  and  the  outcome  is 
doubtful.1 

Credit  insurance  is  a  comparatively  new  type  of  indemnity,  which 
is  offered  by  three  leading  companies.  The  object  of  this  kind  of 
insurance,  as  its  name  indicates,  is  to  protect  business  men  (whole¬ 
salers  and  manufacturers)  against  the  risk  of  extraordinary  losses  due 
to  insolvency  on  the  part  of  their  debtors. 

The  policy  offered  contains  a  number  of  distinctive  features. 
In  the  first  place,  the  insured  must  bear  a  stipulated  initial  loss 
before  the  insurer  has  any  liability.  This  amount  is  known  as  the 
normal  loss,  and  is  figured  on  the  basis  of  the  average  loss  ratio  to 
gross  sales  for  the  preceding  five  years.  Second,  the  maximum 
amount  which  will  be  paid  on  account  of  a  single  loss  is  restricted 
to  an  agreed  percentage  of  the  customer’s  capital  rating  as  supplied 
by  a  reputable  mercantile  agency.  Third,  the  principle  of  coinsurance 
is  applied,  but  in  a  manner  somewhat  different  from  that  used  in  fire 
insurance.  In  the  case  of  customers  who  have  first  credit  ratings, 
the  insured  carries  10  per  cent  of  the  loss;  in  the  case  of  those  who 
have  a  lower  rating,  33J  per  cent.  The  insured  cannot,  as  in  fire 
insurance,  get  rid  of  this  residual  risk  by  insurance  with  another 
company.  Fourth,  the  total  liability  of  the  company  is  usually,  but 
in  the  newer  policies  not  always,  limited  to  a  stipulated  maximum. 
Fifth,  the  losses  covered  are  those  which  arise  from  insolvencies 
which  occur  during  the  life  of  the  policy  or  within  15  days  there¬ 
after.  Insolvency  is  defined  very  broadly  for  purposes  of  the  policy, 
however,  including  death  or  disappearance  of  the  debtor,  assign¬ 
ment  by  the  debtor,  recording  of  a  chattel  mortgage  on  his 
property,  etc. 

Judged  by  the  total  amount  of  losses  incurred,  the  hazard  of  losses 
through  insolvency  of  debtors  is  comparable  in  importance  to  the  fire 
hazard,  as  is  shown  by  the  following  table: 

1 V.  N.  Valgren,  “Crop  Insurance,”  Bull.  U.S.  Dept,  of  Agriculture ,  No.  1043, 
January  23,  1922. 


MISCELLANEOUS  PROPERTY  INSURANCE 


325 


Failure  and  Fire  Losses  for  10  Years* 


Failure  Loss 

Fire  Loss 

1921 . 

$750, 200,000 
426,300,000 
115,500,000 
137,900,000 
166,600,000 
175,200,000 
284,100,000 
357,100,000 
292,300,000 
198,900,000 

$332,654,950 

330,853,925 

269,000,775 

290,659,885 

250,752,640 

214,530,995 

172,033,200 

221,439,350 

203,763,550 

206,438,900 

IQ20 . 

IOIQ . 

1918 . 

1017 . 

1916 . 

IQI  C . 

IOI4 . 

IQI? . 

IQI  2 . 

Total . 

$2,904, 100,000 

$2,492,428,170 

*  Huebner,  Property  Insurance,  p.  526. 


It  is  not  sound  to  argue  from  these  figures,  as  has  sometimes 
been  done,  that  the  business  man’s  need  of  credit  insurance  is  com¬ 
parable  to  his  need  of  fire  insurance.  The  test  of  the  desirability  of 
any  form  of  insurance  is  the  unpredictable  character  of  the  loss,  not 
its  total  amount.  Whereas  the  fire  losses  are  concentrated  in  a  very 
high  degree,  so  that  only  a  small  minority  of  business  men  suffer  fire 
loss  in  any  given  year,  and  that  minority  suffer  very  heavily,  the  risk 
of  loss  from  bad  debts  is  widely  distributed,  falling  in  some  degree 
upon  nearly  everyone  who  extends  credit,  in  every  year.  In  so  far 
as  the  loss  from  bad  debts  runs  the  same  from  year  to  year,  it  can  be 
taken  care  of  as  one  of  the  regular  costs  of  doing  business,  and  there 
is  no  more  need  of  insurance  against  it  than  against  any  other  expense. 
It  is  in  recognition  of  this  fact  that  the  limitation  of  liability  to  loss 
above  a  stipulated  normal  is  included  in  the  provisions  of  every  credit 
policy.  Were  this  not  done  it  would  be  necessary  to  increase  the 
premiums  by  a  large  fraction  of  the  normal  loss1  and  there  would  also 
be  a  significant  increase  in  the  moral  hazard. 

The  regularity  of  credit  losses  in  the  individual  experience,  as 
compared  with  the  experience  with  fire,  arises  from  the  fact  that  the 
business  man  nearly  always  has  a  better  distribution  of  his  credit  risk 
than  he  has  of  his  fire  risk.  With  a  few  hundred  accounts  the  opera¬ 
tion  of  the  law  of  large  numbers  assures  a  high  degree  of  regularity 
in  so  far  as  the  risks  are  independent.  The  chief  protection  afforded 

1  Not,  however,  as  has  sometimes  been  stated,  by  the  full  amount  of  the 
normal  loss.  The  added  amount  of  claims  to  be  paid  would  never  equal  the  amount 
of  the  normal  loss  on  all  the  policies,  as  there  arj  always  some  policies  on  which 
the  loss  in  a  given  year  is  below  the  normal  amount. 


326 


RISK  AND  RISK-BEARING 


by  the  policy  is  against  the  hazard  of  crisis,  which  corresponds  in 
credit  insurance  to  conflagration  hazard  in  fire  insurance.  The1  busi¬ 
ness  man  is  really  in  the  position  of  the  small  fire  insurance  company, 
rather  than  in  that  of  the  holder  of  a  few  pieces  of  exposed  property. 
The  insurance  company  reinsures  if  it  has  a  few  risks  too  large  to  be 
carried  safely  in  dependence  on  the  working  of  the  law  of  averages,  or 
if  it  gets  too  many  risks  exposed  to  the  hazard  of  a  single  conflagra¬ 
tion;  likewise  credit  insurance  is  chiefly  valuable  in  guarding  against 
the  crisis  hazard,  or  in  protecting  a  line  containing  a  few  dispro¬ 
portionately  large  risks.  Whether  the  crisis  hazard  is  great  enough 
to  justify  insurance  of  a  well-balanced  line  of  credit  risks  is'a  question 
in  regard  to  which  opinions  may  well  differ,  as  the  crisis  hazard  itself 
changes  from  year  to  year.  That  the  hazard  is  still  far  from  negligible 
is  indicated  by  the  experience  of  the  leading  credit  insurers,  which 
showed  losses  amounting  to  3  per  cent  of  premiums  in  1919  and  89 
per  cent  in  1920. 

Miscellaneous  Property  Insurance.  Other  standard  types  of 
property  insurance,  which  it  is  not  necessary  to  describe  in  detail, 
cover  such  varied  hazards  as  personal  accidents;  burglary  and  theft 
or  personal  property;  breakage  of  plate  glass  (in  this  case  the  company 
agrees  to  replace  the  glass  or  pay  its  actual  value,  so  that  there  is  no 
limit  to  the  company’s  liability  in  case  the  glass  advances  in  value 
after  the  policy  is  written);  steam  boiler  explosion  (which  involves 
a  much  larger  element  of  prevention  of  loss  than  do  most  types  of 
insurance);  electric  engine  damage;  water  damage;  sprinkler  leakage, 
etc. 


CHAPTER  XVI 


GUARANTY  AND  SURETYSHIP 

V 

I.  INTRODUCTION 

The  type  of  specialization  which  involves  the  assumption  of  risk 
by  a  specialist  who  believes  that  he  can  foresee  the  outcome  of  a 
venture  and  decides  that  there  is  no  risk,  or  a  smaller  risk  than  is 
generally  estimated,  finds  most  of  its  illustrations  in  speculation. 
Outside  this  field,  illustrations  are  found  in  contracts  of  guaranty  and 
suretyship  and  in  certain  types  of  so-called  insurance  which  are  really 
more  properly  considered  as  surety  arrangements.  For  instance,  a 
title  insurance  company  guarantees  real  estate  titles,  not  by  figuring 
the  percentage  of  losses  and  calculating  a  premium  to  cover  the  risk, 
as  is  the  insurance  practice,  but  by  searching  the  records  until  it  is 
satisfied  that  no  risk  exists.  For  the  private  individual  who  cannot 
conduct  this  investigation  for  himself,  the  contract  removes  an  impor¬ 
tant  risk;  for  the  company  the  risk  is  negligible. 

So  with  individual  guaranties.  When  a  friend  signs  a  card  to 
enable  one  to  draw  books  from  a  municipal  library,  he  does  not  inquire 
what  per  cent  of  guarantors  are  called  upon  to  make  good  the  losses 
sustained  by  the  library;  he  depends  absolutely  upon  his  friend’s  per¬ 
forming  his  obligations,  though  he  is  doubtless  aware  that  some  people 
do  not  do  so.  He  believes  his  friend  is  individually  a  safe  risk,  what¬ 
ever  the  average  may  be.  The  library,  not  sharing  this  faith,  considers 
that  the  guaranty  reduces  a  real  risk. 

In  the  same  way,  when  A  indorses  B’s  note  as  an  accommodation 
he  may  know  perfectly  well  that  i  per  cent  of  the  business  men  in  the 
United  States  are  likely  to  fail  within  a  year,  but  he  does  not  figure 
that  he  is  running  a  i  per  cent  risk;  he  believes  B  is  all  right  and  will 
not  be  among  the  i  per  cent.  If  he  had  any  doubt  about  it,  he  would 
probably  decline  to  furnish  the  indorsement.  A  bank  acceptance 
is  exactly  the  same  sort  of  transaction.  The  bank  accepts  drafts 
drawn  on  it  on  account  of  a  customer,  depending  on  him  to  provide 
the  necessary  funds  before  the  draft  falls  due.  It  does  not  charge 
an  actuarial  premium  based  on  statistics  of  risk ;  it  merely  charges  a 
commission  for  the  service.  Unless  it  considers  itself  safe  it  does  not 
accept  the  draft.  To  the  drawer  of  the  draft,  who  does  not  share  the 

327 


328 


RISK  AND  RISK-BEARING 


bank’s  knowledge  or  its  confidence  in  the  customer’s  reliability,  the 
bank’s  acceptance  makes  the  transaction  less  risky.. 

In  foreign-exchange  transactions  certain  individuals  or  firms  of 
excellent  standing  buy  the  paper  of  small  firms  which  have  not  estab¬ 
lished  their  reputation,  add  their  own  indorsement  and  resell  the  paper 
in  the  open  market  at  a  higher  price.  They  know,  or  at  least  they  are 
convinced,  that  the  less-known  firms  are  sound;  but  the  general  public 
not  being  so  fully  informed,  the  well-known  indorsement  adds  to  the 
market  value  of  the  paper.  Here  again  we  have  a  reduction  of  risk 
through  specialization  in  securing  more  adequate  information  than 
is  generally  available. 

The  ordinary  practice  of  underwriting1  security  issues  involves  a 
similar  principle.  An  investment  banking-house  or  a  syndicate 
guarantees  the  sale  of  an  issue  of  securities,  often  knowing  in  advance 
exactly  where  the  buyers  are  to  be  found;  and  in  other  cases  consider¬ 
ing  that  there  is  no  significant  risk  of  failure  to  dispose  of  the  issue. 
The  commission  is  indeed  often  in  part  an  actuarial  premium  for  risk 
undergone,  but  it  is  chiefly  a  compensation  for  service  rendered  in 
investigating  the  proposal  and  in  facilitating  the  sale  by  its  indorse¬ 
ment. 

Of  the  numerous  ways  in  which  business  men  transfer  risk  to 
specialists  who  do  not  carry  a  corresponding  risk,  because  of  superior 
knowledge  or  because  of  ability  to  prevent  losses,  two  are  selected 
for  detailed  examination,  corporate  suretyship,  and  the  protection 
of  buyers  of  real  estate  against  defects  in  titles. 

II.  CORPORATE  SURETYSHIP 

Corporate  suretyship  has  been  described  a?  follows: 

The  business  of  suretyship  as  defined  in  the  insurance  law  of  New 
York  is: 

1.  Guaranteeing  the  fidelity  of  persons  holding  positions  of  public  or 
private  trust. 

2.  Guaranteeing  the  performance  of  contracts  other  than  insurance 
policies. 

3.  Executing  or  guaranteeing  bonds  or  obligations  in  actions  or  pro¬ 
ceedings  or  by  law  allowed. 

It  will  be  seen  from  this  that,  in  a  general  way,  except  as  to  insurance 
policies,  a  surety  company  may,  and  generally  will  guarantee  that  a  particu- 

1  The  term  “underwriting”  is  here  used  in  its  narrower  meaning  of  guaranteeing 
1  sale,  as  distinguished  from  the  loose  usage  of  the  term  as  equivalent  to  outright 
purchase  for  resale. 


GUARANTY  AND  SURETYSHIP 


329 


lar  principal  will  do  any  lawful  thing  specified,  provided  the  security  is 
satisfactory  to  the  surety  company  and  a  reasonable  compensation  is  paid. 
To  really  understand  suretyship,  one  must  separate  fidelity  insurance  from 
the  other  branches.  Fidelity  insurance  is  handled  as  any  other  line  of  casu¬ 
alty  insurance  would  be,  and  while  reliance  is  placed  upon  salvage,  neverthe¬ 
less  the  real  reliance  is  upon  the  fact  that  only  a  certain  very  small  proportion 
of  men  are  likely  to  be  dishonest.  It  is  accordingly  underwritten  as  an  insur¬ 
ance  proposition.  All  the  other  lines,  sometimes  specifically  spoken  of 
collectively  as  surety  lines,  are,  however,  underwritten  upon  the  theory  that 
there  is  a  sound  and  competent  principal  who  will  perform  the  condition  of 
the  bond;  and  the  surety  does  not  seriously  contemplate  the  possibility  of 
being  required  to  pay  the  bond,  but  considers  that  what  he  furnishes  in  return 
for  the  fee  paid  is  merely  a  service.  In  other  words,  by  signing  the  bond  as 
surety,  he  extends  credit  to  the  principal.  Suretyship  is  just  as  much  the 
granting  of  credit  as  is  banking,  the  only  difference  being  that  the  bank 
furnishes  to  its  customer  the  use  of  current  funds,  while  the  surety  furnishes 
its  customer  with  the  opportunity  to  do  something  which  he  otherwise 
would  not  be  able  to  do,  or  enables  him  to  avoid  the  necessity  of  doing 
something  until  the  contingency  occurs  which  makes  it  certain  he  must  do  it.1 

Formerly,  it  was  the  custom  for  individuals  who  were  called  upon 
to  furnish  bond  for  any  purpose  to  make  application  to  individual 
friencjs  and  acquaintances,  as  is  still  the  practice  for  the  most  part  in 
furnishing  bonds  for  appearance  of  alleged  criminals  to  answer  charges 
against  them.  For  most  purposes,  however,  the  advantages  of  cor¬ 
porate  suretyship  are  so  great  that,  within  the  fifty  years  since  it  was 
introduced  in  this  country,  it  has  almost  entirely  supplanted  the  sys¬ 
tem  of  individual  suretyship  except  in  criminal  business  and  in  the 
furnishing  of  surety  for  the  payment  of  small  promissory  notes. 

Corporate  suretyship  offers  several  very  distinct  advantages  over 
the  system  of  individual  guaranties.  In  the  first  place,  it  substitutes 
an  impersonal  business  relationship  for  personal  accommodation.  The 
result  of  this  is  that  the  assured  is  relieved  of  embarrassment  and  from 
a  sense  of  obligation  to  reciprocate.  Moreover,  especially  in  the  case 
of  bonded  public  officials,  individual  suretyship  may  create  an  oppor¬ 
tunity  for  the  guarantor  to  exercise  pressure  in  the  direction  of  an 
undesirable  use  of  official  discretion.  Finally,  the  courts  are  prone 
to  be  very  lenient  in  interpreting  responsibility  of  individual  guaran¬ 
tors  when  they  are  called  upon  unexpectedly  to  fulfil  an  obligation. 
In  the  second  place,  corporate  suretyship  affords  a  better  security, 

1  Adapted  from  advertising  literature  published  by  the  American  Surety 
Company,  New  York,  1919. 


330 


RISK  AND  RISK-BEARING 


for  the  resources  of  the  insurer  are  much  larger  in  proportion  to  the 
requirements  of  any  one  bond  than  is  likely  to  be  the  case  with  individ¬ 
ual  guarantors. 

The  types  of  bonds  usually  written  by  surety  companies  may  be 
described  as  follows:1 

Fidelity  bonds  protect  employers  against  breach  of  trust  and  also 
in  some  cases  against  negligence.  In  writing  this  insurance,  great 
emphasis  is  placed  upon  such  factors  as  character,  family  connections> 
income,  standards  of  living  and  associates,  yet  the  number  of  losses  is 
very  great.  Most  of  these  losses  apparently  arise  from  one  of  three 
sets  of  conditions:  hrst,  extravagance  and  dissipation;  second,  specu¬ 
lation  and  gambling;  third,  loose  accounting  and  mingling  of 
employers’  funds  with  personal  funds. 

Fiduciary  bonds  cover  the  liability  of  trustees.  The  most  impor¬ 
tant  are  those  given  in  probate  proceedings  and  in  insolvency.  In 
these,  as  in  most  of  the  types  of  suretyship  hereafter  enumerated,  the 
moral  risk  is  relatively  small,  but  there  are  many  opportunities  for 
the  insurer  to  become  involved  in  liability  on  account  of  carelessness 
or  ignorance  concerning  his  very  technical  obligations. 

Public  official  bonds  are  required  in  most  cases  where  individuals 
are  intrusted  with  the  care  of  public  funds.  The  liability  under  this 
form  of  suretyship  usually  extends  to  any  responsibility  which  may 
attach  to  the  principal  on  account  of  negligence  or  ignorance,  as  well 
as  actual  breach  ot  trust. 

Judicial  bonds  are  given  chiefly  by  defendants  to  stay  execution, 
and  pay  judgments;  sometimes  to  cover  the  liability  of  plaintiffs  for 
wrongful  pursuit  of  a  remedy  to  which  they  are  not  entitled. 

Criminal  bail  bonds  guarantee  the  appearance  of  a  defendant  for 
trial.  The  moral  hazard  m  this  sort  of  suretyship  is  of  course  very 
great.  It  is  usual,  therefore,  to  require  that  the  principal  deposit 
collateral  security  with  the  insurer  to  cover  its  liability.  In  some  cases, 
the  courts  refuse  to  accept  such  bonds  on  the  ground  that  a  bondsman 
who  is  fully  secured  has  no  incentive  to  produce  his  principal  for  trial: 
hence  the  probability  of  forfeiture  is  too  great  to  be  consistent  with  the 
public  interest  in  securing  the  actual  appearance  of  the  defendant. 

Admiralty  bonds  are  given  by  owners  of  vessels  to  secure  the  pay¬ 
ment  of  claims  and  damages,  in  order  that  the  vessels  may  not  have 

1  The  following  description  is  based  in  part  on  Corporate  Suretyship,  an  address 
by  First  Vice-President  R.  R.  Brown,  of  the  American  Surety  Company  of  New 
York,  to  the  department  of  economics  and  social  institutions  of  Princeton  Uni¬ 
versity  (pamphlet,  reprinted  irom  the  Weekly  Underwriter,  New  York,  not  dated). 


GUARANTY  AND  SURETYSHIP 


331 


to  be  held  within  the  jurisdiction  of  the  court  while  a  case  is  awaiting 
trial,  and  by  the  owners  and  consignees  of  goods  which  are  likely  to 
be  held  liable  for  a  contribution  on  account  of  the  loss  occasioned  by 
the  jettison  of  other  parts  of  the  cargo  or  of  parts  of  the  vessel’s  rigging 
and  equipment. 

Depository  bonds  secure  the  repayment  of  deposits  by  banks; 
usually  deposits  of  public  funds. 

Customs  and  internal  revenue  bonds  are  written  in  many  forms. 
They  secure  the  observance  of  revenue  laws  and  regulations,  or  the 
payment  of  customs  duties  on  goods  released  from  the  control  of 
customs  officials.  Goods  intended  for  re-export,  for  instance,  may  be 
covered  by  a  bond  guaranteeing  the  payment  of  duties  in  case  they 
are  not  actually  shipped  out. 

Warehouse  bonds  guarantee  the  performance  of  duties  by  ware¬ 
housemen.  Their  purpose  is  chiefly  to  enable  the  owner  of  goods 
in  storage  to  secure  credit  on  the  security  of  the  goods. 

License ,  occupation ,  and  permit  bonds  secure  the  observance  of 
law  by  persons  engaged  in  regulated  occupations,  such  as  plumbers, 
saloon-keepers,  bonded  abstracters,  etc. 

Contract  bonds  secure  the  performance  of  obligations  under  con¬ 
tract.  This  is  a  very  large  and  important  class  of  surety  obligations. 
Bonds  are  required  in  connection  with  nearly  all  large  construction 
enterprises.  Such  bonds  are  very  hazardous  because  of  the  numerous 
circumstances  which  may  occasion  default  on  the  part  of  a  building 
contractor,  and  the  great  expense  involved  securing  the  completion 
of  an  unfinished  contract.  Bonds  are  also  required  by  the  United 
States  government  in  connection  with  the  performance  of  mail  service 
and  the  furnishing  of  almost  every  kind  of  supplies.  Supply  bonds 
involve  chiefly  the  risk  that  the  contract  will  become  a  source  of  loss 
on  account  of  advancing  prices;  contracts  for  the  performance  of  mail 
service  are  extremely  hazardous,  as  specific  performance  is  usually 
required. 

Lost  security  bonds  indemnify  a  corporation  in  case  of  loss  arising 
from  the  replacement  of  a  lost  instrument  which  is  later  found.  Such 
bonds  are  always  required  when  claim  is  made  that  a  stock  certificate 
or  bond  has  been  lost  or  destroyed.  This  type  of  bond  involves  very 
little  risk  to  the  bonding  company. 

m.  INSURANCE  OF  REAL  ESTATE  TITLES 

The  title  to  real  estate  affords  an  excellent  illustration  of  the  possi¬ 
bility  of  reducing  risk  through  research.  To  the  average  man  without 


332 


RISK  AND  RISK-BEARING 


expert  assistance,  the  elements  of  risk  involved  in  a  purchase  of  real 
estate  on  a  simple  warranty  deed  are  very  great.  Years  after  the 
property  has  been  paid  for  and  large  sums  have  been  spent  in  its 
improvement,  a  defective  title  may  result  in  an  actual  loss  of  posses¬ 
sion,  or,  more  frequently,  a  clouded  title  may  necessitate  expense  in 
order  to  clear  up  the  doubt.  On  the  other  hand,  if  sufficient  care  is 
taken  it  is  almost  always  possible  at  any  given  time  to  discover  all  the 
flaws  in  a  title,  and  enable  a  purchaser  to  take  the  property  with  very 
little  risk.  Three  principal  methods  accomplishing  this  purpose  are 
in  use  in  the  United  States. 

Bonded  abstracters. — The  simplest  system  is  the  employment  of  a 
bonded  abstracter.  Under  this  plan,  the  buyer  or  the  seller  of  property 
employs  a  professional  abstracter  to  draw  up  an  abstract  of  title, 
which  is  then  submitted  to  an  attorney  for  an  opinion.  The  abstracter 
is  legally  liable  if  a  loss  occurs  as  the  result  of  his  failure  so  to  prepare 
the  abstract  as  to  show  the  facts  of  record  concerning  the  title,  and 
is  heavily  bonded  to  insure  the  payment  of  such  damages. 

This  system  is  widely  used  in  the  rural  sections  of  the  West  and 
works  satisfactorily  in  the  great  majority  of  cases.  (Indeed  any  sys¬ 
tem  works  satisfactorily  in  the  majority  of  cases  for  the  reason  that 
there  are  usually  no  unknown  defects  of  title  which  can  cause  trouble 
no  matter  what  system  of  protection  is  employed.)  The  system  is 
incomplete,  however,  for  there  are  numerous  possible  defects  which 
are  beyond  the  field  of  the  abstracter’s  investigation-— for  instance  a 
forged  deed  may  be  recorded  and  the  abstracter  will  have  no  way  of 
detecting  the  forgery,  or  there  may  be  an  undiscovered  heir  whose 
rights  are  not  a  matter  of  record.  Moreover,  there  is  always  the  risk 
that  careless  reading  of  the  abstract  or  inefficient  advisory  work  by 
the  attorney  may  cause  a  loss  in  cases  where  the  abstract  actually 
discloses  a  flaw  in  the  title.  Finally,  in  the  older  sections  of  the 
country,  where  transfers  have  been  numerous,  the  mere  physical  labor 
of  searching  records  and  copying  abstracts  makes  this  method  unduly 
expensive. 

Title  insurance. — In  these  older  sections,  especially  in  cities,  the 
most  popular  method  of  dealing  with  title,  risks  is  through  the  services 
of  a  title  insurance  company.  Such  a  company  usually  has  a  virtual 
monopoly  of  the  business  in  a  limited  territory  and  therefore  operates 
on  a  sufficiently  large  scale  to  justify  the  expense  of  maintaining 
elaborate  files,  from  which  the  information  necessary  to  pass  on  a 
given  title  can  be  obtained  quickly  and  economically. 


GUARANTY  AND  SURETYSHIP 


333 


The  policy,  which  is  perpetual  in  its  force,  insures  not  only  against 
the  establishment  of  an  actual  defect  in  the  title,  but  also  against  any 
expense  which  may  be  involved  in  defending  title,  and  against  any 
damage  which  may  be  sustained  because  of  the  refusal  of  a  buyer  to 
accept  the  property  on  account  of  alleged  defects  in  the  title. 

Before  issuing  such  a  policy,  the  insurer  makes  a  careful  examina¬ 
tion  of  the  records  and  lists  in  the  policy  all  known  defects,  and  also 
certain  possible  unknown  defects  which  are  not  matters  of  record. 
Loss  from  these  listed  defects  is  then  excepted  from  the  protection  of 
the  policy.  Thus  the  policy  serves  the  double  purpose  of  a  report  on 
the  existing  state  of  the  title  and  a  guarantee  against  loss  due  to  error 
and  omission  in  the  report. 

The  essential  difference  between  the  protection  afforded  by  such  a 
policy  and  that  afforded  under  the  bonded  abstracter  system  is  that 
in  the  latter  case  protection  extends  only  to  the  result  of  negligence 
or  wilful  error  on  the  part  of  the  abstracter,  while  in  the  case  of  the 
title  quarantee  company  it  extends  to  numerous  potential  defects 
which  are  beyond  the  possible  knowledge  of  any  of  the  parties  to  the 
contract.  The  more  important  of  the  possible  flaws  which  are  not 
discoverable  through  searching  of  the  records  are  excepted  from  the 
provisions  of  the  policy,  however,  so  that  the  risk  actually  taken  by 
the  company  is  very  small. 

The  following  quotations  from  the  form  used  by  a  prominent 
title  insurance  company  indicate  the  character  of  the  protection 
afforded: 

The  X  Title  and  Trust  Company  shall  have  the  right  to,  and  will,  at  its 
own  cost  and  charges,  defend  the  party  guaranteed  in  all  actions  of  eject¬ 
ment  or  other  action  or  proceeding  founded  upon  a  claim  of  title,  incum¬ 
brance  or  defect,  which  existed  or  is  claimed  to  have  existed  prior  in  date  to 
this  policy  and  not  excepted  herein;  reserving,  however,  the  option  of  set¬ 
tling  the  claim  or  paying  this  policy  in  full . 

Loss  or  damage  by  reason  of  special  taxes  or  special  assessments  which 
have  not  been  confirmed  by  a  court  of  record,  conveyances  or  agreements 
not  of  record  at  the  date  of  this  policy,  or  mechanics’  liens  when  no  notice 
thereof  appears  of  record  are  not  covered  by  it.1 

In  addition  to  the  limitation  of  liability  just  quoted,  each  policy 
contains  a  special  schedule  of  “estates,  defects  or  objections  to  title, 
and  liens,  charges  and  incumbrances  thereon,  which  do  or  may  now 

1  The  quotations  are  from  the  form  used  by  a  western  company.  For  full 
standard  form  adopted  by  the  New  York  Board  of  Title  Underwriters,  see  Huebner, 
Property  Insurance  (revised),  pp.  513-19. 


334 


RISK  AND  RISK-BEARING 


exist,  and  against  which  the  Company  does  not  guarantee.”  The  fol¬ 
lowing  quotations  from  this  schedule  in  a  recent  policy  are  typical: 

1.  Conditions  contained  in  the  deed  made  by  John  E.  Brown  and  wife 
to  Margaret  A.  Short  dated  November  5,  1894,  and  recorded  November  5, 
1894,  as  document  218475,  that  no  building  shall  be  placed  on  the  east 
thirty-five  feet  of  the  premises  in  question. 

2.  Party  wall  rights,  if  any. 

3.  Special  assessment  warrant  36783  for  paving  Johnstone  Avenue, 
confirmed  March  n,  1919,  for  $108.63  on  premises  in  question,  payable  in 
five  installments,  the  last  four  unpaid. 

4.  Taxes  for  the  year  1920. 

Title  policies  are  not  assignable,  except  when  issued  to  protect 
mortgages.  At  each  transfer  a  new  policy  is  issued  to  protect  the 
new  buyer.  The  cost  of  subsequent  policies  is  considerably  less  than 
that  of  the  first,  as  little  work  has  to  be  done  to  bring  the  record  down 
to  date. 

The  losses  paid  by  title  insurance  companies  are  far  smaller  than 
is  the  case  with  any  other  type  of  insurance;  indeed  in  many  cases 
purely  nominal  losses  are  sustained  for  years  at  a  time.  The  premium 
is  based  on  the  service  rendered  in  searching  the  title  rather  than  on 
the  risk  assumed.  Nevertheless,  though  the  amount  lost  on  account 
of  defects  which  are  not  discovered  through  searching  records  and  are 
not  excepted  (such  as  forged  deeds,  spurious  powers  of  attorney,  deeds 
executed  by  lunatics,  undiscovered  heirs),  the  loss  in  the  few  instances 
where  such  flaws  exist  is  likely  to  be  very  serious  for  the  persons  con¬ 
cerned,  and  a  system  by  which  such  risks  are  transferred  at  small  cost 
to  a  responsible  insurer  provides  a  real  social  gain. 

The  Torrens  system. — A  third  method  of  furnishing  security  against 
defects  in  title,  which  has  been  introduced  in  recent  years  in  certain 
parts  of  the  United  States,  is.  the  so-called  Torrens  system.  This  is  a 
system  of  public  registration  whereby  at  each  transfer  of  title  the  pur¬ 
chaser  is  given  either  an  indefeasible  title  or  a  guarantee  of  reimburse¬ 
ment  in  case  the  title  proves  defective. 

In  the  original  Torrens  system,  which  was  established  in  Australia 
in  the  latter  fifties,  an  administrative  body  was  authorized  to  search 
the  title,  and  in  the  event  that  no  defect  appeared,  the  claimant  in 
actual  possession  was  given  a  certificate  entitling  him  to  absolute 
ownership.  A  small  assessment  on  all  property  registered  under  this 
system  provided  a  fund  from  which  compensation  was  made  to  any 
holders  on  unsatisfied  claims  who  might  be  deprived  of  their  rights 
through  such  registration. 


GUARANTY  AND  SURETYSHIP 


335 


The  system  has  had  a  limited  application  in  England  and  a  con¬ 
siderable  popularity  in  Canada,  and  within  the  last  few  years  has  been 
adopted  in  modified  form  in  about  a  dozen  American  states.  Under 
the  law  of  some  of  these  states,  registration  does  not  give  an  inde¬ 
feasible  title,  and  the  fund  provided  by  registrants  is  used  to  compen¬ 
sate  holders  of  the  registration  certificates,  in  case  error  is  discovered, 
instead  of  previous  holders  of  title  as  under  the  original  Torrens  sys¬ 
tem.  In  other  states,  the  registrant  is  given  an  indefeasible  title,  but 
this  is  done  through  a  formal  suit  to  clear  the  title,  and  not  through 
the  action  of  administrative  officers. 

In  theory,  the  principle  of  the  Torrens  law  provides  a  distinct 
improvement  over  any  of  the  other  systems.  It  does  not  seem  neces¬ 
sary  that  in  a  community  where  land  has  been  held  by  private  individ¬ 
uals  for  many  generations,  investigators  should  at  every  transfer 
review  the  entire  history  of  the  title  and  reopen  the  question  of  the 
validity  of  each  alleged  transfer,  as  is  the  practice  under  the  bonded 
abstracter  system.  Nor  does  it  seem  an  ideal  system  that  the  com¬ 
munity  should  depend  for  so  essential  a  service  upon  the  preservation 
of  the  records  of  a  private  company  and  the  maintenance  of  its  ser¬ 
vices,  as  is  the  case  where  the  title  insurance  system  is  used.  The 
Torrens  system,  by  clearing  the  slate  at  each  transfer,  greatly  sim¬ 
plifies  the  whole  question. 

In  most  cases,  the  initial  expense  of  registration  is  somewhat 
greater  under  the  Torrens  system  than  in  the  guarantee  of  title  by  a 
title  insurance  company,  and  this  cost  falls  upon  a  seller  who  has  no 
interest  in  the  economy  which  will  result  in  connection  with  future 
transfers.  For  this  reason,  possibly  also  because  of  the  influence  of 
the  title  companies,  and  also  because  of  administrative  weaknesses 
and  doubts  in  some  quarters  as  to  constitutionality,  the  progress  of 
the  Torrens  system  in  America  has  been  slow.  The  only  places  in 
which  it  has  apparently  had  a  significant  development  are  Cook 
County,  Illinois,  and  the  state  of  Massachusetts,  and  even  there,  so 
far  as  volume  of  business  is  concerned,  it  is  overshadowed  by  the  title 
insurance  companies. 


CHAPTER  XVII 
RISKS  OF  LABOR 

I.  INTRODUCTION 

As  was  indicated  in  chapter  iii,  the  present  industrial  organization 
contemplates  the  transfer  to  the  business  man  of  certain  of  the  risks 
associated  with  production,  and  a  corresponding  increase  in  the  secu¬ 
rity  of  the  other  factors  in  production.  Under  all  ordinary  circum¬ 
stances,  the  laborer  can  count  on  receiving  his  pay  for  his  co-operation 
in  an  enterprise  quite  regardless  of  the  ultimate  success  of  the  enter¬ 
prise.  Not  only  does  the  employer’s  capital  stand  between  the  laborer 
and  the  risks  which  beset  the  productive  process,  but  to  a  large  extent 
those  who  extend  credit  to  the  business  manager  in  any  other  way  have 
their  claims  subordinated  to  those  of  the  laborer. 

Nevertheless,  the  position  of  the  worker  is  never  free  from  certain 
elements  of  risk.  This  arises  in  part  from  the  impossibility  of  framing 
a  labor  contract  in  such  a  way  that  all  the  risk  of  the  business  is  borne 
by  the  management,  and  secondarily  from  the  fact  that  the  worker 
must  himself  carry  the  risk  of  being  unable  to  find  continuously  an 
opportunity  to  enter  into  an  advantageous  contract  for  the  selling  of 
his  labor.  A  group  of  students  of  the  labor  problem  have  summarized 
the  situation  as  follows: 

To  carry  the  analysis  into  the  field  of  labor,  the  worker,  if  he  learns  a 
trade,  takes  the  risk  that  the  demand  for  his  services  will  be  inadequate  to 
give  him  full-time  employment  at  a  living  wage;  he  takes  the  risk  that  there 
may  be  more  workers  in  the  trade  than  can  be  employed;  he  takes  the  risk 
of  changes  in  the  technique  of  production  eliminating  the  need  for  his  skill 
and  throwing  him  into  competition  with  myriad  unskilled  workers;  he  takes 
the  risk  of  being  injured  or  becoming  infected  by  occupational  disease;  he 
takes  the  risk  of  being  made  a  nervous  wreck  by  the  “roar  and  rhythm" 
of  the  machine;  and  always  there  is  the  risk  that  public  demand  for  the 
product  in  the  manufacture  of  which  he  is  engaged  may  cease  and  leave  him 
out  of  a  job,  unfitted  to  do  the  work  demanded  in  other  lines  of  industry 

Labor  trouble  is  a  source  of  danger  to  the  business  manager,  but  it  also 
threatens  the  worker.  If  he  goes  on  a  strike  to  better  wages  or  working 
conditions  he  runs  a  chance  that  the  organization  of  which  he  is  a  member  will 
not  be  strong  enough  to  win  the  strike  or  that  strike  benefits  will  be  insuffi 

336 


RISKS  OF  LABOR 


337 


dent  to  keep  himself  and  his  family  alive.  If  the  strike  arouses  public  ill  will, 
anti-labor  legislation  may  limit  freedom  of  action  on  the  part  of  labor  organi¬ 
zations  thus  tending  to  perpetuate  the  uncertain  conditions  against  which  he 
went  on  strike. 

And  so  it  goes.  Inadequate  income  whether  due  to  unemployment, 
industrial  old  age,  sickness,  accidents,  industrial  conflict,  or  low  wages  bring 
risks  of  undernourishment  which  brings  the  risk  of  impaired  efficiency  which, 
if  it  occurs,  increases  the  risks  of  accident,  disease,  and  low  wages.  Children 
brought  into  the  world  may  have  to  grow  up  under  the  handicaps  imposed 
by  such  risks  and  this  adds  another  risk  to  the  already  heavy  load  of  uncer¬ 
tainty  which  the  worker  has  to  bear. 

Indeed  it  can  be  said  with  a  certain  degree  of  accuracy  that  the  worker 
assumes  all  the  risks  of  the  employer  and  in  addition  bears  some  unique 
to  himself.  In  common  with  all  individuals  he  runs  the  risk  of  death,  acci¬ 
dent,  fire,  war,  disease,  etc.,  the  risks  due  to  his  carelessness  which  includes 
many  accidents  and  deaths,  and  the  risks  due  to  the  dishonesty  on  the  part 
of  the  worker  or  others;  as  a  member  of  the  working  class  he  bears  the  unique 
risks  of  unemployment,  underemployment,  or  overemployment,  long  hours, 
the  risk  of  inadequate  wages,  the  risks  arising  out  of  the  antagonism  between 
specialists,  the  risks  of  specialization,  the  risks  due  to  the  characteristics  of 
the  machine,  the  risks  of  anti-labor  legislation,  and  the  risks  of  competition 
from  his  fellows;  in  particular  industries  he  runs  the  risk  of  seasonal  employ¬ 
ment,  of  occupational  disease,  of  sweating,  of  accidents,  or  moral  devolution.1 

The  risks  which  the  laborer  shares  with  the  rest  of  the  race  we 
may  well  leave  without  detailed  consideration.  Our  particular  inter¬ 
est  is  in  the  risks  which  arise  directly  from  his  connection  with  the 
economic  process.  Of  these  by  far  the  most  important  are  the  risks 
of  unemployment  and  of  industrial  accident  and  occupational  diseases. 

II.  UNEMPLOYMENT 

Exact  figures  for  the  volume  of  unemployment  are  not  available ,  but 
the  estimates  made  by  competent  investigators  agree  in  showing,  first, 
a  high  degree  of  variability  in  the  amount  of  unemployment,  and, 
second,  an  appreciable  amount  of  unemployment  at  the  busiest  sea¬ 
sons  of  the  most  prosperous  years.  Omitting  agricultural  labor  from 
consideration,  it  appears  that  during  the  last  twenty  years  the  amount 
of  unemployment  in  the  United  States  has  fluctuated  from  a  probable 
minimum  of  1,000,000  to  a  possible  maximum  of  6,000,000,  out  of  a 
total  number  of  workers  estimated  as  about  30,000,000  during  the 
latter  part  of  the  period.  To  some  extent,  the  significance  of  the 

1  From  Douglas,  Hitchcock,  and  Atkins,  The  Worker  in  Our  Modern  Economic 
Society  (preprint,  chap.  v).  The  University  of  Chicago  Press,  1923. 


33§ 


RISK  AND  RISK-BEARING 


maximum  figures  is  reduced  by  the  probability  that  a  considerable 
expansion  of  agricultural  employment  coincided  with  the  minimum 
of  industrial  employment,  but  the  extent  of  this  absorption  of  the 
unemployed  has  not  been  estimated. 

The  distribution  of  the  cost  of  unemployment  is  very  uneven. --In  the 
case  of  approximately  half  the  working  group,  the  loss  due  to  this  cause 
is  negligible,  while  within  the  other  half  there  are  very  wide  individual 
variations. 

Unemployment  is  a  market  risk. — Each  manual  laborer  has  to  sell 
a  definite  amount  of  labor  service,  each  item  of  which  represents  an 
irreplaceable  impairment  of  his  stock  in  trade.  At  the  outside,  the 
manual  laborer  can  rarely  sell  more  than  twelve  thousand  days’ 
service  during  his  working  life;  the  average  figure  is  probably 
nearer  six  thousand.  Unemployment  is  simply  the  failure  to  market 
a  part  of  his  stock  in  trade.  The  seriousness  of  this  hazard  arises 
fundamentally  from  the  fact  that  his  labor  is  a  “perishable  com¬ 
modity.”  Every  day’s  service  must  be  sold  at  a  given  time  or  not 
at  all. 

The  difficulty  is  aggravated  by  the  inelastic  character  of  the  price 
of  labor.  In  times  of  slack  demand,  it  would  frequently  be  to  the 
laborer’s  immediate  interest  to  sell  his  time  at  a  cut  price,  just  as  a 
merchant  finds  it  advantageous  to  clear  his  shelves  by  bargain  sales, 
but  the  market  is  so  organized  that,  as  a  rule,  the  laborer  cannot,  by 
price-cutting,  stimulate  an  increase  in  demand  for  his  services.  He 
can  sell  his  time  at  the  going  rate  demanded  by  his  competitors  or  he 
cannot  sell  it  at  all.  Some  decline  of  wages  takes  place  in  time  of 
declining  demand, but  to  a  large  extent  labor  is  “deflated”  in  periods 
of  depression  by  a  decrease  in  the  amount  of  labor  sold  rather  than 
by  a  decline  in  its  price.1 

1  This  is  much  less  true  of  agricultural  than  of  industrial  labor.  Independent 
farmers  lose  by  the  decline  of  the  price  of  their  products,  and  the  relationship 
between  the  employing  and  employed  groups  in  agriculture  is  so  close  that  even 
the  hired  laborer  in  this  field  of  employment  is  relatively  free  from  the  risk  of 
unemployment,  and  finds  his  wage  fluctuating  rather  sharply  with  the  level  of 
prices  for  the  products  of  the  farm. 

Whether  labor,  as  a  whole,  gains  by  this  custom  of  holding  up  wages  in  times 
of  dull  business  and  accepting  unemployment  is  doubtful.  There  can  be  little 
doubt  that  a  sharp  readjustment  of  wages  downward,  in  times  of  liquidation,  would 
contribute  greatly  to  the  shortening  of  the  ensuing  depression.  Laborers  who  are 
most  certain  of  employment  would  lose;  those  who  bear  the  burden  of  unemploy¬ 
ment  would  gain;  the  net  result  for  the  time  being  would  probably  be  a  gain. 
Whether  this  gain  would  be  offset  by  the  difficulty  of  gettiig  wages  up  again  as 


RISKS  OF  LABOR 


339 


In  any  discussion  of  the  causes  of  unemployment,  a  distinction 
should  be  maintained  between  the  conditions  which  determine  the 
amount  of  unemployment  at  any  given  time  and  those  which  deter¬ 
mine  the  selection  of  individuals  to  bear  the  burden  of  the  unemploy¬ 
ment.  The  amount  of  unemployment  in  any  industry  is  determined 
chiefly  by  conditions  for  which  the  workers  in  that  industry  are  indi¬ 
vidually  responsible  to  a  trifling  extent. 

Unemployment  arises  chiefly  from  six  causes:  ( a )  seasonal  fluctua¬ 
tion  in  the  activity  of  specific  industries;  ( b )  cyclical  fluctuation  in  the 
activity  of  business  in  general,  as  well  as  of  specific  industries;  (c)  the 
necessity  of  maintaining  a  reserve  of  unemployed  labor  in  order  to 
insure  the  smooth  working  of  the  industrial  machine,  as  was  pointed 
out  in  chapter  ii;  (d)  labor  troubles;  (e)  interruption  of  production 
from  causes  peculiar  to  the  individual  establishment,  such  as  fire, 
bankruptcy,  consolidation  of  plants,  shutdown  for  lack  of  transpor¬ 
tation  or  of  raw  material,  overstocking  with  finished  goods,  and  similar 
causes;  (/)  personal  incapacity  and  inefficiency,  and  shiftlessness. 

The  factor  named  last  is  not  co-ordinate  with  the  other  five,  how¬ 
ever,  but  overlaps  them.  The  first  five  causes  determine  how  much 
employment  there  shall  be  at  a  given  time;  the  sixth  helps  to  determine 
which  individuals  shall  be  left  out.  Assuming  that  the  economic 
situation  is  such  as  to  dictate  the  unemployment  of  io  per  cent  of  the 
labor  supply,  what  determines  which  of  the  laborers  shall  make  up 
this  io  per  cent?  In  part,  the  answer  is,  chance.  Shutdown  on 
account  of  fire,  for  instance,  affects  the  efficient  and  the  inefficient 
alike.  Reduction  of  forces  on  account  of  decline  in  the  volume  of 
orders,  on  the  other  hand,  gives  opportunity  for  a  sifting  of  the  labor 
force,  especially  where  the  number  of  employees  is  large,  with  the 
result  that  personal  characteristics  play  a  very  large  part  in  determin¬ 
ing  where  the  ax  shall  fall.  Moreover,  even  in  cases  where  the  unem¬ 
ployment  arises  from  conditions  which  affect  a  whole  group  of  workers 
alike,  the  personal  efficiency,  the  energy,  and  the  co-operative  spirit  of 
the  laborer  determine  in  large  part  what  shall  be  the  duration  of  his 
unemployment.  For  the  best  workman,  a  position  is  usually  to.be 
found  quickly;  for  the  mediocre  and  the  low-grade  worker  the  loss 

business  revived  one  can  only  conjecture;  it  is  a  question  of  the  relative  importance 
of  bargaining  power  and  actual  productive  value  in  determining  wage  scales.  A 
system  of  very  elastic  wage  scales  would  make  it  possible  for  industry  to  pay  higher 
average  wages  than  it  can  now  pay;  the  inelastic  system  makes  it  somewhat  easier 
to  compel  industry  to  pay  as  much  as  it  can. 


340 


RISK  AND  RISK-BEARING 


of  a  job  is  much  more  likely  to  mean  serious  loss  of  time  before  employ¬ 
ment  can  once  more  be  obtained. 

Not  all  the  unemployment  represents  waste,  either  from  the  social 
standpoint  or  from  that  of  the  laborer.  From  the  standpoint  of  soci¬ 
ety,  the  loss  of  time  incident  to  maintaining  an  adequate  reserve  of 
labor,  the  unemployment  incident  to  shifting  laborers  from  time  to 
time  to  more  productive  employment,  and  the  time  necessarily  lost 
on  account  of  seasonal  fluctuations  in  business,  are  all  parts  of  the 
cost  of  running  the  industrial  machine,  and  are  no  more  to  be  accounted 
wastes  than  is  the  time  of  laborers  engaged  in  eating  and  sleeping. 

From  the  laborer’s  standpoint,  also,  the  loss  of  time  incident  to 
seeking  and  obtaining  better  conditions  of  work  must  be  regarded  as 
an  investment  rather  than  a  waste. 

In  like  manner,  the  unemployment  which  is  the  result  of  labor  dis¬ 
putes  represents,  from  the  standpoint  of  the  laborer,  an  investment 
intended  to  increase  the  selling  value  of  part  of  his  labor  time  by  sacri¬ 
ficing  the  income  from  a  smaller  part.  If  the  labor  market  were 
perfectly  fluid,  such  dissipation  of  labor  power  would  represent  a  sheer 
waste,  for  it  would  be  practicable  for  anyone  who  was  dissatisfied  with 
the  conditions  of  his  employment  to  transfer  himself  to  another  field 
where  the  compensation  and  conditions  of  work  were  more  satisfactory. 
The  labor  market,  however,  is  an  imperfect  market;  it  is  not  practi¬ 
cable  for  the  laborer  who  believes  himself  ill  paid  to  transfer  himself  to 
another  employment  without  loss  of  time,  direct  money  cost,  and  con¬ 
siderable  risk.  Consequently,  the  effort  to  improve  those  conditions 
by  interruption  of  service  may  well  be,  from  the  individual  standpoint, 
profitable.  From  the  social  standpoint,  it  represents  a  waste  just  in  so 
far  as  there  exists  a  better  method  of  insuring  the  adjustment  of  wages 
to  changing  conditions  of  demand  and  supply  in  the  labor  field.  Cer¬ 
tainly  it  is  a  cumbersome  and  expensive  method  of  maintaining  the 
relationship  between  wages  in  a  given  industry  and  the  conditions 
which  determine  a  fair  wage  in  that  industry;  yet  this  loss  cannot  be 
labeled  a  complete  waste  till  a  better  method  of  accomplishing  its 
purpose  is  demonstrated  to  be  practicable. 

Of  the  causes  of  unemployment  enumerated,  the  seasonal  fluctua¬ 
tion  is  the  most  important,  so  far  as  numbers  indicate  importance,  but 
the  significance  of  this  factor  is  greatly  lessened  by  the  extent  to  which 
it  is  compensated,  either  by  wage  rates  or  by  the  possibility  of  making 
profitable  use  of  the  idle  time.  The  extent  to  which  dovetailing  of 
employment  is  possible  depends  chiefly  on  the  technique  of  the  indus- 


RISKS  OF  LABOR 


341 


try,  and  on  the  extent  to  which  the  amount  and  time  of  the  employ¬ 
ment  is  known  in  advance.  Some  occupations,  such  as  coal-mining, 
unfit  the  laborer  for  the  most  accessible  alternate  employments;  others, 
such  as  farming,  do  not  interfere  directly  with  the  laborer’s  fitness  for 
a  variety  of  other  employments,  but  coincide  in  their  slack  and  busy 
seasons  with  most  of  the  occupations  in  which  alternative  employment 
could  otherwise  be  secured  most  readily;  others,  such  as  teaching, 
dovetail  well  with  numerous  other  occupations  which  furnish  profitable 
employment  during  the  slack  season. 

The  extent  to  which  the  rate  of  pay  in  any  occupation  adjusts  itself 
to  the  worker’s  necessity  of  losing  time,  on  account  of  seasonal  fluctua¬ 
tions,  depends  on  two  factors,  namely,  the  extent  to  which  dovetailing 
is  usually  practicable,  and  the  degree  of  certainty  in  the  unemployment. 
Any  condition  limiting  the  total  amount  of  employment,  if  it  is  cer¬ 
tain,  is  fairly  sure  to  be  compensated  for  in  the  wage,  but  competition 
is  not  so  effective  in  compensating  for  the  uncertain  but  probable  losses. 
Even  if  the  wage  in  a  given  occupation  adjusts  itself  so  that  the  average 
compensation  for  a  year’s  service  is  sufficient  to  cover  idle  as  well  as 
working  time,  it  would  still  be  true  that  many  individuals  would  suffer 
from  less  than  average  employment.  Moreover,  if  the  amount  lost 
by  each  individual  is  highly  uncertain,  it  is  much  more  likely  to  be 
under-  than  over-compensated  for  the  average  worker.  The  effect  of 
the  unemployment  hazard  on  wages  is  merely  to  keep  them  high 
enough  so  that  workers  are  willing  to  take  the  risk;  if  even  a  minority 
of  workers  overestimate  the  amount  of  employment  they  are  likely  to 
have,  the  wage  adjustment  may  be  such  as  to  leave  the  average  worker 
the  loser.  In  practice,  the  adjustment  of  wages  to  irregularity  in  the 
volume  of  employment  seems  to  vary  widely  from  industry  to  industry, 
being  most  accurate  in  cases  like  teaching  where  the  idle  time  is  known 
accurately  in  advance,  and  least  satisfactory  in  cases  where  a  high 
degree  of  irregularity  combines  with  a  low  standard  of  life  and  inade¬ 
quate  appreciation  of  the  risk  on  the  part  of  the  worker. 

Ways  of  dealing  with  the  risk  of  unemployment  are  numerous. — 
Private  employment  agencies  and  newspaper  advertising  serve  to 
shorten  the  interval  between  jobs  by  reducing  the  amount  of  work 
necessary  for  worker  and  employer  to  get  in  touch  with  one  another. 
Scientific  labor  administration,  including  such  devices  as  job  analysis, 
rating  cards,  and  all  administrative  methods  and  policies  which  aim 
at  the  creation  of  harmony  and  a  spirit  of  co-operation  within  an  indus¬ 
trial  organization — all  these  serve  to  reduce  the  turnover  of  labor,  and 


342 


RISK  AND  RISK-BEARING 


incidentally  the  risk  of  unemployment.  Public  employment  agencies 
aim  to  effect  a  more  economical  adjustment  of  demand  and  supply  in 
the  labor  field  than  that  effected  by  the  private  agencies.  All  plans 
for  the  stabilization  of  industry  (with  primary  reference  to  the  reduc¬ 
tion  or  elimination  of  the  cyclical  fluctuation)  include,  among  their 
objectives,  the  reduction  of  the  amount  of  unemployment  which  char¬ 
acterizes  the  depression  stage.  Diversification  of  one’s  preparation, 
so  as  to  make  possible  the  dovetailing  of  employment,  aids  individuals 
to  meet  the  exigencies  of  the  situation. 

Finally,  it  remains  to  consider  the  possibility  of  dealing  with  this 
risk  through  insurance.  In  most  respects  unemployment  presents  a 
good  example  of  the  kind  of  risk  for  which  insurance  offers  a  satisfac¬ 
tory  palliative.  The  incidence  of  unemployment  is  frequent  enough 
to  keep  the  laborer  alive  to  the  importance  of  provision  against  it;  it 
is  not  so  great  in  amount  that  insurance  against  it  involves  a  prohibi¬ 
tive  cost;  it  affects  different  individuals  at  different  times  and  from 
different  causes,  so  that  (in  spite  of  the  concentration  of  losses  occa¬ 
sioned  by  a  downswing  of  the  business  cycle)  the  catastrophe  hazard 
is  not  a  serious  bar  to  the  underwriting  of  the  risk.  The  moral  hazard 
would  be  very  great  if  full  protection  were  offered,  but  the  insurer 
could  be  protected  against  this  danger,  as  in  credit  insurance,  by 
requiring  the  insured  to  bear  a  fixed  “normal  loss”  and  to  coinsure  for 
a  fixed  percentage  of  the  remainder.  Insurance  to  the  amount  of  50 
or  60  per  cent  of  wages  for  unemployment  beyond  a  certain  number  of 
days  (the  number  varying  with  the  industry)  would  hardly  stimulate 
a  significant  amount  of  deliberate  unemployment. 

The  chief  obstacle  to  the  writing  of  such  insurance  arises  from  the 
wide  variation  in  the  hazard  on  different  individual  risks;  the  difficulty 
in  measuring  this  difference;  and  the  certainty  of  serious  adverse 
selection  in  case  such  measurement  is  not  effected  and  utilized  in  rate¬ 
making.  If  flat  rates  were  charged,  without  attention  to  individual 
variations  in  employability,  there  would  undoubtedly  be  a  tendency 
for  poor  risks  to  insure  and  the  good  risks,  the  men  who  rarely  have 
trouble  in  finding  jobs,  to  carry  their  own  risk.  There  is  also  to  be 
considered  the  possibility  that  kind-hearted  employers,  confronted 
with  the  necessity  of  reducing  forces,  would  deliberately  select  for 
dismissal  those  who  were  protected  by  insurance  against  unemploy¬ 
ment.  For  these  reasons,  the  ordinary  form  of  insurance,  which  looks 
to  the  self-interest  of  each  individual  to  induce  him  to  take  out  such 
insurance  as  he  needs,  does  not  meet  the  situation. 


RISKS  OF  LABOR 


343 


On  the  other  hand,  some  method  by  which  whole  groups  of  laborers 
might  be  insured,  without  opportunity  for  adverse  selection,  might 
serve  a  very  useful  purpose.  One  device,  which  has  been  used  for  the 
purpose  in  a  number  of  cases,  and  appears  possible  of  wider  service 
in  this  way,  is  insurance  through  the  trade  union.  Membership  in  a 
union  depends  primarily  upon  other  considerations,  so  that  there  is 
no  tendency  for  the  poor  risks  to  predominate  among  the  insured;  the 
amount  paid  is  small  enough  so  that  there  is  no  incentive  to  malinger¬ 
ing,  and  the  organization  has  better  than  average  facilities  for  deter¬ 
mining  the  genuinemess  of  claims  against  it. 

The  weakness  of  this  method  consists  in  the  fact  that  the  insurance 
feature  of  trade  union  policy  is  subordinate  to  other  features,  and  is 
therefore  likely  to  be  sacrificed  to  attain  some  other  end.  In  almost 
every  instance  where  insurance  benefits  are  offered  by  a  trade  union, 
the  funds  contributed  by  members  for  that  purpose  are  commingled 
with  those  collected  for  other  purposes,  and  are  likely  to  be  used  for 
the  promotion  of  ends  which  have  no  relation  to  insurance.  From 
the  typical  trade-union  official  viewpoint,  the  insurance  feature  is  a 
means  of  obtaining  and  keeping  members,  or  collecting  additional 
revenue  from  them,  rather  than  a  primary  purpose  of  the  organization. 
Were  an  attempt  made  to  collect  from  the  membership  sufficient  funds 
to  cover  adequately  the  risk  of  unemployment,  the  insurance  feature 
would  become  so  expensive  as  to  weaken  rather  than  strengthen  the 
organization. 

It  does  not  seem  probable  that  the  risk  of  unemployment  can  be 
removed  by  voluntary  insurance,  paid  for  by  the  workers,  either 
through  the  trade  union  or  through  a  commercial  insurance  company. 
There  remain  the  possibilities  of  insurance  at  the  cost  of  the  state,  of 
the  employer,  or  of  some  combination  of  these  with  one  another  or 
with  insurance  at  the  cost  of  the  worker.  Subsidized  public  insurance, 
both  voluntary  and  compulsory,  has  been  tried  in  a  number  of  Euro¬ 
pean  countries,  the  most  notable  experiment  being  that  now  carried 
on  by  the  British  government  under  the  Unemployment  Insurance 
Act  of  1920  (an  extension  of  the  National  Insurance  Act  of  1911). 
Under  this  system,  the  cost  of  insurance  is  borne  jointly  by  the 
employer,  the  employee,  and  the  state.  This  joint  support  removes, 
in  large  part,  the  fundamental  objection  to  a  system  of  insurance 
which  does  not  adjust  the  premium  to  the  known  difference  of  hazard 
in  the  individual  case.  With  about  60  per  cent  of  the  cost  borne  by 
the  state  and  the  employer,  even  the  individual  who  believes  himself 


344 


RISK  AND  RISK-BEARING 


to  be  a  high-grade  risk  will  not  be  so  likely  to  complain  of  being  over¬ 
charged  when  he  is  required  to  pay  at  the  same  rate  as  is  charged  his 
less  employable  fellow-worker,  though  in  the  case  of  the  best  workmen 
even  40  per  cent  of  the  average  loss  is  probably  an  overcharge.  The 
compulsory  feature  secures  for  the  insurer  a  proper  distribution  of 
the  risk.  The  contribution  of  the  state  is  offset,  in  part  at  least,  by 
the  saving  in  poor  relief,  both  public  and  philanthropic,  which  results 
from  the  operation  of  the  insurance  fund,  and  the  effect  of  public 
relief  extended  in  this  way  is  perhaps  less  demoralizing  than  would 
be  the  case  if  it  were  extended  directly  as  poor  relief.  The  compulsory 
contribution  of  employers  is  defended  on  the  ground  that  the  cost  of 
unemployment  incident  to  the  operation  of  a  given  industry  is  a  part 
of  the  cost  of  running  the  industry,  and  ought  to  be  so  assessed  as  to 
appear  in  the  price  of  the  product,  or  in  the  profit  account  of  the 
employer. 

The  weakness  of  the  plan,  aside  from  serious  administrative  diffi¬ 
culties,  lies  in  the  absence  of  any  plan  of  merit  rating  by  which  the 
employer  may  be  given  an  incentive  to  stabilize  his  operations,  or  the 
employee  an  incentive  to  increase  his  own  employability.  An  insur¬ 
ance  system  which  merely  equalizes  burdens  is  useful,  but  it  falls  short 
of  its  highest  possibilities  unless  it  does  something  to  reduce  the  total 
amount  of  losses.  It  may  be  too  much  to  expect  that  any  practicable 
system  of  rating  individual  risks  will  give  the  worker  more  incentive 
than  he  now  has  to  rise  into  the  class  of  steady  workers  who  are 
relatively  free  from  the  risks  of  unemployment,  but  in  the  case  of  the 
employer  there  seem  to  be  distinct  possibilities  of  gain  in  this  direction. 
In  the  light  of  the  great  progress  which  has  been  made  ii.  recent  years 
in  the  elimination  of  irregularities  in  the  operation  of  industrial  plants,1 
compulsory  unemployment  insurance  which  fails  to  reward  or  penalize 
marked  departures  from  the  usual  proportion  of  idle  time  fails  of  its 
highest  potential  usefulness. 

It  may  be  added  that  the  political  organization  of  the  United  States 
makes  it  more  difficult  here  than  abroad  to  maintain  a  national  system 
of  unemployment  insurance,  with  its  necessarily  minute  research  into 
local  conditions;  while  state  organization  presents  very  undesirable 
aspects  on  account  of  the  extent  to  which  the  employers  of  one  state 
are  in  direct  competition  with  those  of  another,  while  their  employees 
are  drawn  from  a  common  source  and  move  freely  from  one  state  to 

1  For  example,  in  this  country  by  the  Dennison  Manufacturing  Company 
and  by  the  Joseph  and  Feiss  Company. 


RISKS  OF  LABOR 


345 


another.  Unemployment  insurance  under  political  control  does  not 
appear  to  be  a  probable  development  of  the  immediate  future,  in  the 
United  States. 

Another  possibility  of  the  reduction  of  unemployment  is  the  delib¬ 
erate  expansion  of  public  works  in  times  of  depression.  This  plan 
offers  the  double  advantage  of  equalizing  the  incomes  of  laborers,  con¬ 
tractors,  and  others  by  furnishing  them  employment  during  periods 
of  dulness  in  industry,  and  of  offering  a  probability  of  economy,  con¬ 
struction  costs  being  lowest  at  such  times.  In  so  far  as  public  works 
promise  to  serve  a  real  social  need  when  completed,  and  are  at  the  same 
time  not  of  so  urgent  a  character  as  to  make  it  inadvisable  to  wait  for 
depression  eras  in  order  to  undertake  them,  this  plan  is  thoroughly 
sound.  The  chief  difficulty  in  its  practical  application  arises  from 
circumstances  similar  to  those  which  interfere  with  the  concentration 
of  construction  work  by  corporations  in  times  of  low  cost,  namely  the 
difficulty  of  financing  enterprise  at  such  times,  or  securing  authorization 
to  carry  them  forward.  A  time  when  general  business  is  very  slack 
and  employment  scarce  is  fairly  certain  to  be  a  time  when  the  burden  of 
taxation  is  felt  to  be  abnormally  heavy,  and  legislatures  and  electorates 
are  prone  to  economize  at  such  times.  Proposals  to  undertake  heavy 
expenditures  for  purposes  that  are  not  urgent  receive  grudging 
support. 


m.  ACCIDENT  AND  OCCUPATIONAL  DISEASE 

The  risk  of  industrial  accident  and  occupational  disease  presents  a 
problem  both  in  social  policy  and  in  individual  financial  management 
which  is  very  similar  to  that  presented  by  unemployment.  In  each 
case  there  is  a  considerable  element  of  risk  which  cannot  be  eliminated 
by  preventive  measures,  and  another  considerable  element  which  can 
be  eliminated  if  proper  incentives  are  given  those  who  are  responsible 
for  the  conditions  under  which  industry  is  carried  on,  both  employers 
and  laborers.  In  each  case  the  hazard  varies  greatly  from  one  industry 
to  another;  and  in  each  case  the  financial  loss  is  divided  between  the 
employer,  the  public,  and  the  laborers  themselves.  In  each  case  the 
financial  loss  inflicted  upon  the  majority  is  small  enough  so  that  no 
serious  problem  exists,  while  the  loss  in  individual  cases  is  so  great  as 
to  make  the  hazard  very  serious.  The  variation  of  the  risk  from  one 
individual  to  another,  under  like  conditions  of  employment,  is  not 
as  great  as  in  the  case  of  unemployment  hazard,  but  is  neverthe¬ 
less  so  great  that  it  is  necessary  to  take  account,  in  the  determina- 


346 


RISK  AND  RISK-BEARING 


lion  of  a  wise  policy,  of  the  effect  on  the  worker’s  incentive  to  exercise 
his  best  efforts  to  reduce  the  hazard. 

The  statistics  of  industrial  accident  are  more  complete  than  those 
for  unemployment,  and  the  loss  shows  a  much  greater  degree  of  regu¬ 
larity  from  year  to  year.  The  number  of  fatal  industrial  accidents  in 
the  United  States  has  been  estimated  at  25,000  for  1913,  and  23,000 
for  1919;  those  involving  four  weeks  or  more  of  disability  at  700,000 
for  the  former  year  and  575,000  for  the  latter. 

The  burden  of  the  loss  from  personal  accidents  is  distributed  in 
various  ways.  Much  of  it  falls  directly  on  the  workers  affected; 
another  portion  probably  falls  initially  on  the  employer  through  the 
necessity  of  paying  higher  wages  in  the  more  dangerous  occupations; 
another  part  is  assumed  by  the  public  in  the  form  of  poor  relief,  and 
through  the  cost  of  maintaining  machinery  for  adjudicating  claims 
arising  out  of  accidents;  another  part  is  shifted  to  employers  and 
others  who  may  be  responsible  through  voluntary  or  compulsory  pay¬ 
ment  of  damages,  through  payments  under  compensation  laws,  and 
through  insurance  against  liability;  some  small  part  is  distributed 
over  the  working  group  through  the  medium  of  private  insurance. 
Some  of  these  methods  are  of  sufficient  importance  to  warrant  detailed 
examination. 

There  is  no  evidence  that  wage  rates  adjust  themselves  accurately  to 
the  risk  of  accident. — It  has  been  argued  that  there  is  little  need  of 
public  action  with  a  view  to  allocating  the  burden  of  accidents  more 
equitably,  for  the  reason  that  competitive  wages  can  be  depended  upon 
to  equalize  this,  as  it  does  other  differences  in  the  attractiveness  of 
different  forms  of  employment.  The  weakness  in  this  form  of  argu¬ 
ment  is  the  assumption,  first,  that  in  practice  the  degree  of  risk  asso¬ 
ciated  with  any  form  of  accident  is  known  to  the  parties  to  the  wage 
contract  well  enough  to  make  it  a  reasonable  basis  of  adjustment  of 
wages,  and,  second,  in  the  assumption  that  even  if  such  adjustment 
were  effected  the  result  would  be  to  equalize  the  burden.  It  may  be 
granted  that  if  the  number  of  accidents  which  will  occur  in  each 
establishment  could  be  predicted  accurately,  and  were  known  to  all 
prospective  applicants  for  such  employment,  and  all  such  appli¬ 
cants  were  rational  in  their  choices,  the  wages  paid  would  have 
to  compensate  the  group  as  a  whole  for  the  total  loss  due  to  acci¬ 
dents,  and  the  burden  would  fall  either  on  the  capitalists  employing 
them,  the  consumers  of  the  product  of'  the  industry,  or,  conceivably, 
on  the  public  at  large.  Even  then,  as  was  pointed  out  in  discussing 


RISKS  OF  LABOR 


347 


a  similar  situation  in  connection  with  the  risk  of  unemployment,  the 
result,  in  the  absence  of  an  effective  system  of  insurance,  would  be  to 
bestow  extra  compensation  upon  the  majority  who  escape  the  hazard, 
and  not  to  remove  the  burden  from  those  who  now  suffer  it. 

But  the  outstanding  characteristic  of  the  situation  is  the  absence 
of  certainty  concerning  the  amount  of  loss  which  will  be  incurred,  and 
the  certainty  of  selection  adverse  to  the  workers.  For  if  some  workers 
overestimate  and  others  underestimate  the  risk,  it  matters  not  whether 
the  average  estimate  is  too  high  or  too  low.  The  effective  amount  of 
risk  is  the  risk  as  estimated  by  those  who,  in  numbers  sufficient  to  man 
the  industry,  are  disposed  to  rate  it  lowest.  Familiarity  breeds 
indifference,  so  that  those  who  best  know  the  risks  of  a  trade  are  most 
apt  to  ignore  them.  Notoriously,  many  men  have  an  unin telligent  faith 
in  their  own  good  luck;  others  shrink  from  being  thought  afraid;  and 
many  are  ignorant  of  the  hazards  involved  in  the  pursuits  which  they 
choose.  These  are  the  men  whose  choices  determine  the  excess  of 
wages  to  be  paid  in  dangerous  occupations;  the  services  of  the  timid 
or  even  the  intelligently  cautious  worker  are  rarely  needed  in  occupa¬ 
tions  where  danger  is  really  great.1 

The  accident  risk  is  rarely  covered  by  personal  insurance  by  workers. — 
The  same  factors  which  obstruct  any  tendency  for  wages  to  adjust 
themselves  to  the  hazard  of  a  given  employment  also  obstruct  the 
progress  of  private  insurance  as  a  palliative.  If  workers  underesti¬ 
mate  the  degree  of  risk  in  a  given  trade,  they  are  not  likely  to  pay  the 
premiums  demanded  for  insurance  by  an  insurance  company  which 
must  figure  the  risk  conservatively  high  and  add  a  loading  for  expense 
and  profit.  Moreover,  in  the  absence  of  a  definite  assurance  that 
wages  are  high  enough  to  compensate  for  the  risk  undergone,  the 
effect  of  insurance  at  the  expense  of  the  workers  is  merely  to  equalize 
the  burden  they  are  assuming  without  adequate  compensation;  it 
increases  the  burden  for  the  group  as  a  whole.  Casualty  companies 
do  write  a  considerable  amount  of  personal  insurance  to  protect  against 
the  risk  of  accidents,  but  this  is  carried  chiefly  by  professional  and  busi¬ 
ness  men  rather  than  by  laborers. 

Liability. — It  was  noted  above  that  a  part  of  the  accident  hazard 
is  transferred  to  employers,  or  other  responsible  persons,  through  the 

1  Cf.  A.  S.  Johnson,  Introduction  to  Economics ,  pp.  205-7.  A  careful  theoret¬ 
ical  analysis  of  this  question  is  found  in  R.  M.  Woodbury,  Social  Insurance ,  an 
Economic  Analysis,  pp.  56-70.  Mr.  Woodbury  has  also  examined  the  statistical 
evidence,  and  concludes  that  the  data  are  entirely  inadequate  either  to  prove  or  to 
disprove  the  existence  of  any  tendency  for  wages  to  adapt  themselves  to  the  degree 
of  risk. 


348 


RISK  AND  RISK-BEARING 


medium  of  voluntary  or  forced  settlement  of  claims  for  damages.  The 
original  theory  of  the  common  law  does  not  distinguish  the  responsibil¬ 
ity  of  employers  from  that  of  others;  that  is,  they  are  responsible  for 
such  damages  as  may  be  caused  directly  by  their  fault  or  negligence. 

This  liability  was,  during  the  course  of  the  nineteenth  century, 
subjected  to  further  limitation  on  account  of  the  application,  in  cases 
involving  claims  for  damage  done  to  workmen  by  their  employers, 
of  defenses  which  would  not  be  available  in  similar  cases  where  the 
plaintiff  was  not  an  employee.  These  are,  first,  the  defense  of  con¬ 
tributory  negligence,  the  essence  of  which  is  that  in  cases  where  negli¬ 
gence  on  the  part  of  both  employer  and  employee  is  shown  to  have  con¬ 
tributed  to  bring  about  the  accident,  no  damages  can  be  collected;  the 
fellow-servant  doctrine,  which  holds  that  an  employer  is  not  respon¬ 
sible  for  damage  done  to  his  employees  through  carelessness  of  other 
employees;  and  the  doctrine  of  assumption  of  risk,  by  which  the 
laborer  is  held  to  have  waived  his  claim  to  damages  if  he  can  be  shown 
to  have  had  knowledge  of  the  special  hazard  and  accepted  employ¬ 
ment  without  a  special  agreement  guaranteeing  him  compensation 
for  such  accidents  as  might  result.  The  cumulative  effect  of  these 
defenses  was  to  make  it  extremely  difficult  and  expensive  for  an 
employee  to  obtain  compensation  in  such  cases  as  make  up  the  major 
portion  of  the  accidents  to  w  hich  the  laborer  is  exposed,  and  to  place 
upon  him  the  financial  cost  of  numerous  accidents  which  he  could  in 
practice  do  little  to  prevent. 

During  recent  years,  the  situation  has  been  changed  through  the 
general  adoption  of  one  or  the  other  of  two  reforms,  known  respectively 
as  employers’  liability  laws  and  workmen’s  compensation  laws. 

Employer’s  liability  legislation  (widely  adopted  between  1885  and 
1910)  is  simply  legislation  designed  to  modify  the  liability  of  the 
employer,  without  abandoning  the  fundamental  rule  that  the  employer 
is  responsible,  just  as  anyone  else  is  responsible,  for  the  results  of  his 
own  negligence.  Some  states  have  abolished  the  fellow-servant  doc¬ 
trine;  others  limit  its  application  to  certain  industries  or  exclude  from 
its  operation  injuries  due  to  the  fault  of  certain  classes  of  employees. 
There  have  been  also  various  modifications  of  the  doctrine  of  contribu¬ 
tory  negligence,  some  states  providing  for  a  division  of  the  financial 
responsibility,  in  cases  where  negligence  is  shown  on  the  part  of  both 
parties;  others  placing  the  burden  on  the  employer  to  prove  contribu¬ 
tory  negligence  instead  of  requiring  the  employee  to  prove  its  absence, 
as  was  the  case  under  the  common  law. 


RISKS  OF  LABOR 


349 


The  chief  criticisms  of  the  system  of  employers’  liability  as  modi¬ 
fied  by  legislation  are,  first,  that  it  is  unduly  expensive  in  administra¬ 
tion  (on  account  of  the  necessity  of  suits  to  establish  responsibility 
in  a  large  proportion  of  cases) ;  second,  that  it  fails  to  place  properly 
the  cost  of  the  accidents  for  which  neither  employer  nor  employee  is 
directly  responsible;  third,  that  it  has  in  practice  provided  compensa¬ 
tion  for  only  about  one  accident  in  eight  so  that  the  bulk  of  the  cost 
of  accident  has  remained  with  the  working  group,  where  its  incidence 
has  been  most  burdensome,  and  its  effect  least  effective  in  stimulating 
remedial  and  precautionary  effort. 

Workmen’s  compensation. — During  the  years  since  1910  a  new 
principle  has  come  to  be  widely  accepted  for  dealing  with  this  type  of 
risk,  known  as  the  principle  of  compensation.  The  features  which 
differentiate  the  compensation  plan  from  the  systems  which  preceded 
it  may  be  summarized  as  follows:  First,  under  compensation  the  pre¬ 
sumption  is  in  favor  of  assessing  the  cost  of  an  accident  on  the  employer 
instead  of  on  the  employee.  In  cases  where  neither  the  employer  nor 
the  employee  is  guilty  of  negligence,  employers’  liability  places  the 
cost  on  the  employee;  workmen’s  compensation  places  it  on  the 
employer.  Second,  workmen’s  compensation  aims  to  provide,  so  far 
as  possible,  a  fixed  scale  of  benefits  for  each  type  of  injury,  the  amount 
depending  on  the  character  of  the  disability,  the  amount  previously 
earned  by  the  injured  worker,  the  existence  or  non-existence  of  depend¬ 
ents,  and  similar  considerations.  Third,  compensation  benefits  are 
frequently  made  payable  in  the  form  of  annuities,  in  order  that  the 
loss  due  to  the  death  or  permanent  disability  of  the  injured  worker 
may  be  reduced  by  the  replacement  of  his  wages  by  a  similar  type  of 
income;  liability  insurance,  since  it  contemplates  payment  fora  spe¬ 
cific  wrong  already  committed,  favors  immediate  payment  of  damages 
in  a  lump  sum.  Fourth,  compensation  plans  frequently  recognize 
the  desirability  of  requiring  employers  to  protect  their  employees 
from  the  risk  that  the  purpose  of  compensation  may  be  defeated  by  the 
employer’s  bankruptcy  or  withdrawal  from  business. 

Beginning  in  1910,  the  principle  of  compensation  found  very  rapid 
acceptance,  and  only  five  states,  together  with  the  District  of  Colum¬ 
bia,1  now  have  no  compensation  laws.  In  many  of  the  states  listed 
as  having  compensation,  however,  the  number  of  occupations  excluded 
and  in  the  few  cases  the  existence  of  optional  substitutes,  reduce  con¬ 
siderably  the  significance  of  these  figures.  The  following  recent 

1  In  private  employment. 


3So 


RISK  AND  RISK-BEARING 


summary  indicates  the  wide  dissimilarity  between  the  plans  now  in 
use,  the  differences  extending  to  almost  every  point  where  a  difference 
is  possible: 

Compensation  laws  may  be  either  compulsory  or  elective.  A  com¬ 
pulsory  law  is  one  which  requires  every  employer  within  the  scope  of  the 
compensation  law  to  accept  the  act  and  pay  the  compensation  specified. 
An  elective  law  is  one  in  which  the  employer  has  the  option  either  of  accept¬ 
ing  or  of  rejecting  the  act,  but  in  case  he  rejects  the  customary  common-law 
defenses  are  abrogated.  Of  the  45  compensation  jurisdictions  (43  states, 
Alaska,  and  Hawaii),  14  are  compulsory  and  31  are  elective  as  to  compensa¬ 
tion  provisions. 

Scope  or  coverage. — No  state  compensation  act,  even  when  full  use  of 
the  elective  provisions  is  taken  into  account,  covers  all  employees.  The 
principal  exemptions,  in  the  order  of  their  importance,  perhaps,  are:  non- 
hazardous  employments;  agriculture;  domestic  service;  numerical  exemp¬ 
tions,  i.e.,  excepting  employers  having  less  than  a  specified  number  of 
employees;  public  employees,  casual  laborers  or  those  not  employed  for  the 
purpose  of  the  employer’s  business;  and  employments  not  conducted  for 
gain. 

Occupational  diseases. — Eleven  states  and  the  Federal  Government  now 
include  occupational  diseases  among  the  list  of  compensable  injuries.  In 
most  of  these  states  all  occupational  diseases  are  compensated,  but  in  some 
the  coverage  is  limited  to  certain  specified  diseases  and  processes. 

Waiting  period. — In  most  of  the  states  an  injury  to  be  compensable  must 
cause  disability  for  a  certain  length  of  time,  no  compensation  being  paid 
during  this  time.  This  noncompensable  preliminary  period  is  known  as 
the  “waiting  period.”  The  most  common  provision  is  that  disability  must 
continue  for  more  than  one  week,  this  being  found  in  25  states. 

Compensation  scale. — In  all  but  two  states  the  amount  of  compensation 
is  based  upon  wages.  A  number  of  states,  however,  provide  fixed  lump 
sums  or  pensions  for  certain  injuries,  but  apply  the  percentage  system  to  all 
others.  A  few  states  have  varying  percentages  for  different  types  of  injuries, 
and  in  several  states  the  percentage  varies  with  conjugal  condition  and  num¬ 
ber  of  children.  In  19  states  the  amount  of  compensation  is  50  per  cent  of 
the  employee’s  wages:  in  3  states,  55  per  cent;  in  9  states,  60  per  cent,  in 
3  states,  65  per  cent;  and  in  9  states  and  the  Federal  Government,  66§  per 
cent. 

The  compensation  benefits  are  usually  modified  by  weekly  maximum 
and  minimum  limits  which  may  materially  affect  the  amounts.  It  is 
undoubtedly  true  that  under  no  state  compensation  law  does  the  employer 
bear  50  per  cent  of  the  cost  of  industrial  accidents  and  in  most  states  he  bears 
but  20  to  35  per  cent. 


RISKS  OF  LABOR 


351 


The  benefits  for  death  in  most  cases  approximate  three  or  four  years’ 
earnings  of  the  deceased  employee.  Twenty-three  states  place  a  limit  upon 
the  maximum  amount  payable  in  any  one  case.  These  maximum  amounts 
range  from  $3,000  to  $6,000. 

Most  states  recognize  the  fact  that  a  permanently  disabled  workman  is  a 
greater  economic  loss  to  his  family  than  if  he  were  killed  outright  at  the  time 
of  the  accident,  and  consequently  provide  greater  benefits  than  in  case  of 
fatal  accidents.  Eighteen  states  and  the  Federal  Government  provide  that 
for  permanent  total  disability  compensation  payments  shall  continue  for 
the  full  period  of  the  injured  workman’s  life.  Twenty-one  states  place  a 
limit  upon  the  maximum  amount  payable  in  any  one  case;  these  maximum 
amounts  range  from  $3,000  to  $10,000. 

Partial  disability. — Two  methods  for  compensating  partial  disabilities 
are  generally  provided  for.  One  method  is  based  upon  the  percentage  of 
wage  loss  occasioned  by  such  disability,  payments  continuing  during  inca¬ 
pacity  but  subject  to  maximum  limits.  The  second  method  is  the  adoption 
of  a  specific  schedule  of  injuries  for  which  benefits  are  awarded  for  fixed 
periods,  the  payments  being  based  upon  a  percentage  of  wages  earned  at  the 
time  of  the  injury.  Usually  both  methods  of  payment  are  provided  for. 
The  practice  in  most  states  is  to  pay  a  percentage  of  the  wage  for  fixed  periods 
for  certain  enumerated  injuries  and  for  all  other  injuries  a  percentage  of  the 
wage  loss  during  disability. 

Medical  benefits. — Three  states  furnish  no  medical  service  except  that  in 
fatal  cases  involving  no  dependents  the  expenses  of  last  sickness  shall  be 
paid  by  the  employer.  Seven  states  and  the  Federal  Government  provide 
unlimited  service.  Nine  laws  place  no  limitation  upon  the  period  during 
which  medical  treatment  shall  be  furnished,  but  do  limit  the  amount;  while 
seven  limit  the  period,  but  do  not  limit  the  amount.1 

It  remains  to  consider  the  extent  to  which  the  risk  of  industrial 
accident  is  reduced  through  the  operation  of  insurance.  Insurance  to 
cover  this  risk  has  two  quite  distinct  purposes.  It  may  be  taken  out 
for  the  purpose  of  protecting  the  employer  against  the  hazard  he  carries 
under  either  employers’  liability  or  workmen’s  compensation,  or  it 
may  be  required  by  the  state  in  order  to  protect  workmen  against  loss 
from  inability  of  the  employer  to  meet  his  responsibilities  under  the 
law. 

Liability  insurance  is  voluntary. — Before  the  liability  of  employers 
was  generally  increased  through  the  passage  of  the  limiting  legislation 
to  which  reference  was  made  above,  few  employers  felt  it  necessary 

1  Adapted  from  Carl  Hookstadt,  “Workmen’s  Compensation  and  Social  Insur¬ 
ance,”  Monthly  Labor  Review ,  XVI  (January,  1923),  158-69. 


352 


RISK  AND  RISK-BEARING 


to  protect  themselves  by  insurance  against  the  hazard  of  incurring 
liability  for  damages  on  account  of  industrial  accident.  With  the 
passage  of  laws  abrogating  the  customary  defenses,  however,  the  risk 
became  so  serious  that  liability  insurance  became  very  common,  and 
it  still  is  valuable  in  states  where  compensation  systems  have  not  been 
introduced,  and  also  in  the  case  of  the  numerous  occupations  to  which 
compensation  requirements  do  not  apply,  and  in  the  cases  where  indi¬ 
vidual  employers  elect  to  refuse  to  come  under  the  provisions  of 
optional  compensation  arrangements.  This  form  of  insurance  is 
written  chiefly  by  stock  companies. 

Compensation  insurance  is  in  many  cases  compulsory. — Some  form 
of  guarantee  of  financial  ability  is  required  in  nearly  all  the  states 
which  have  adopted  the  principle  of  workmen’s  compensation.  The 
most  common  requirement  is  that  all  employers  who  are  subject  to 
the  provisions  of  the  compensation  law  shall  either  insure  with  licensed 
insurance  carriers,  or  else  provide  what  is  called  “ self-insurance,” 
that  is,  satisfy  the  proper  administrative  body  of  their  ability  to.  carry 
the  risk.  Only  eight  or  ten  states  make  insurance  absolutely  compul¬ 
sory,  while  four  make  no  provision  for  guaranteeing  the  payment  of 
compensation  in  case  the  employer  becomes  bankrupt  or  retires  from 
business.  In  view  of  the  long  period  during  which  compensation 
liabilities  persist,  some  provision  to  assure  the  continuance  of  pay¬ 
ments  is  highly  important. 

Three  principal  types  of  insurance  are  in  use,  namely,  state  funds, 
stock  company  insurance,  and  mutual  insurance.  In  seven  states, 
an  exclusive  fund  is  maintained  by  compulsory  contributions  from 
employers,  and  all  compensation  payments  are  made  from  this 
fund.  In  nine  others,  state  funds  compete  with  private  agencies, 
and  in  the  remaining  states  the  field  is  occupied  only  by  the  private 
agencies. 

Workmen’s  compensation  is  so  new  that  it  is  hazardous  to  venture 
an  opinion  as  to  the  relative  desirability  of  the  three  plans.  In  theory, 
a  monopolistic  state  fund,  if  efficiently  managed,  should  be  able  to 
furnish  the  service  more  economically  than  a  private  carrier,  with  its 
large  selling  costs  and  limited  volume  of  business.  The  state  funds 
actually  in  operation  have  made  an  excellent  showing.  Such  data  as 
have  been  published  (and  several  of  them  have  been  subjected  to  care¬ 
ful  investigation)  indicate  that  the  cost  of  administration  of  accident 
insurance  is  lower  in  the  mutual  than  in  the  stock  companies,  lower 


RISKS  OF  LABOR 


353 


still  in  the  competitive  state  funds,  and  lowest  in  the  exclusive  state 
funds.1 

The  effectiveness  of  public  administration  varies  so  widely  from 
state  to  state,  however,  and  also  from  time  to  time  within  the  same 
state,  that  the  present  body  of  experience  is  hardly  sufficient  to  over¬ 
come  the  hesitancy  of  many  students  of  public  affairs  to  indorse  an 
enlargement  of  the  scope  of  state  administrative  responsibility.  Where 
state  funds  compete  with  private  funds,  the  private  carriers  succeed 
in  obtaining  a  large  volume  of  business,  in  spite  of  higher  costs. 

From  the  standpoint  of  the  employer,  the  great  advantage  of  the 
stock  insurance  company  contract  is  its  definiteness.  The  object  of 
insurance  is  to  remove  uncertainty;  a  contract  which  relieves  the 
employer  of  his  responsibility  in  return  for  a  contractual  premium  does 
this  more  effectively  than  does  a  mutual  or  state  fund  with  its  assess¬ 
ments  dependent  on  the  loss  experience,  so  that  many  employers  are 
willing  to  pay  a  somewhat  higher  average  cost  for  the  sake  of  greater 
freedom  from  uncertainty. 

Rating  in  compensation  insurance. — The  systems  used  in  making 
rates  for  insurance  in  compensation  insurance  are  very  complex.  They 
involve  the  application  of  all  three  of  the  leading  principles  of  rating 
which  were  discussed  in  chapter  xiv  in  connection  with  fire  insurance, 
namely,  classification,  schedule  rating,  and  experience  rating. 

The  starting-point  in  the  determination  of  an  individual  rate  is 
the  manual  rate,  which  is  determined  by  a  study  of  statistics  of  the 
accident  rate  for  a  given  type  of  labor  in  a  given  industry,  modified 
bv  differences  of  experience  in  different  states,  differences  in  the 
liberality  of  different  state  systems  of  compensation,  catastrophe 
hazard,  current  state  of  business  activity  or  depression,  and  profit 
to  the  insurer. 

Such  a  manual  rate,  if  scientifically  calculated,  should  serve  the 
double  purpose  of  producing  a  sufficient  amount  of  revenue  to  meet 
the  requirements  of  compensation,  and  of  distributing  the  cost  as 
equitably  as  it  can  be  distributed  by  advance  calculation,  without 
inspection  of  the  individual  establishment.  It  fails,  however,  to 
accomplish  one  purpose  which  it  is  very  desirable  to  keep  in  the  fore¬ 
ground  of  attention  in  all  discussions  of  policy  with  regard  to  accident, 

T  Cf.  Commons  and  Andrews,  Principles  of  Labor  Legislation,  pp.  411-13 
(Harper  &  Bros.,  1920);  Carl  Hookstadt,  Comparison  of  Workmen's  Compensation 
Insurance  and  Administration,  p.  97  (Government  Printing  Office,  April,  1922). 


354 


SOCIAL  ASPECTS  OF  RISK-BEARING 


namely  to  encourage  activity  designed  to  reduce  the  number  of  acci¬ 
dents. 

Schedule  rating  is  a  system  of  individual  debits  and  credits  for 
favorable  or  unfavorable  features  of  the  individual  risk.  This  type 
of  rating  does  much  to  encourage  the  introduction  of  safety  devices 
and  the  elimination  of  unnecessary  elements  of  hazard  in  the  physical 
surroundings  of  the  workers. 

Physical  surroundings,  however,  are  responsible  for  only  a  minor 
part  of  the  preventable  accidents;  morale  and  discipline  count  for 
more  than  do  any  features  of  plant  and  equipment  which  can  be  listed 
in  a  schedule  and  checked  up  by  the  inspector.  To  take  account  of 
this  factor,  experience  rating  is  sometimes  used.  This  is  a  system 
whereby  employers,  who  have  a  sufficiently  large  body  of  employees 
to  establish  a  probability  of  uniformity  in  the  loss  experience,  receive 
a  modification  of  the  insurance  rate  in  the  light  of  any  marked  depar¬ 
ture  of  their  individual  experience  from  the  general  experience  of  the 
industry  in  which  they  are  engaged.  The  obvious  advantage  of  this 
system  is  that  it  gives  a  direct  incentive  to  individual  effort  to  reduce 
the  accident  loss;  an  incentive  surpassed  only  by  that  which  is  present 
under  so-called  self-insurance.  The  disadvantage  is  that  there  is 
always  present  the  possibility  that  an  unusual  run  of  good  or  bad  luck 
will  result  in  an  adjustment  of  rates  which  is  not  justified  by  the  actual 
conditions  of  operation. 


CHAPTER  XVIII 


SOCIAL  ASPECTS  OF  RISK-BEARING 

In  this  chapter  attention  is  directed  to  the  question  of  the  social 
usefulness  of  certain  institutions,  whose  uses  in  connection  with  the 
transfer  and  reduction  of  risk  have  been  discussed  in  the  pre¬ 
ceding  chapters.  In  this  survey  we  shall  consider,  first,  the  social 
utility  of  the  system  of  free  appropriation  of  profit  by  private  indi¬ 
viduals.  Next,  we  shall  consider  the  ethical  significance  of  three 
specific  devices  for  dealing  with  risk,  namely,  gambling,  insurance, 
and  speculation.  Finally,  the  whole  system  of  modern  industry  and 
trade  will  be  compared  briefly  with  two  other  systems  in  the  light  of 
its  tendency  to  increase  or  decrease  the  risk  element  in  the  lives  of 
those  who  live  under  it. 

I.  SOCIAL  ASPECTS  OF  PROFIT-TAKING 

The  profit  system  is  so  integral  to  the  present  organization  of 
economic  life  that  a  discussion  of  its  merits  really  involves  the  whole 
question  of  the  merits  of  a  capitalistic  society,  to  which  attention  is 
given  in  a  later  section  of  the  chapter.  The  present  section  does  not 
consider  possible  substitutes  for  the  profit  incentive,  but  rather 
certain  points  at  which  that  system  is  susceptible  of  modification 
without  the  abandonment  of  any  of  the  major  features  of  the  economic 
order  under  which  we  live. 

In  chapter  iii  we  indicated  the  relationship  which  exists  between 
risk  and  profit.  Profit,  it  was  there  shown,  arises  from  the  fact  that 
the  amount  of  capital  which  seeks  employment  in  certain  industries, 
or  other  opportunities  for  investment,  is  smaller  than  the  amount 
which  could  be  so  employed  in  them  as  to  earn  for  itself  the  usual 
return.  The  most  frequent  cause  for  such  restriction  of  investment 
in  certain  lines  is  the  existence  of  risk.  We  have  not,  in  our  previous 
survey  of  this  topic,  raised  the  question  of  th e  justification  of  the  profit 
system.  What  we  have  done  is  to  indicate  in  a  very  broad  way  the 
conditions  which  make  it  possible  for  the  individual  owner-manager 
to  collect  a  profit.  Socially  speaking,  there  can  be  only  one  justifica¬ 
tion  for  profit,  namely,  its  service  as  an  incentive  to  individuals  to 
undertake  ventures  where  the  outcome  is  uncertain.  There  is  perhaps 


355 


356 


RISK  AND  RISK-BEARING 


dC 
'.l£ , 


/✓/  0 


no  phase  of  our  modern  industrial  organization  which  has  been  more 
acutely  criticized  of  late  years  than  this  reliance  on  the  motive  of 
private  profit.  To  many  students  the  system  seems  calculated  to 
foster  the  worst  conceivable  distribution  of  the  world’s  goods — exces¬ 
sive  wealth  for  the  few  and  correspondingly  meager  returns  for  the 
many,  while  the  service  it  renders  as  an  incentive  to  productive  effort 
seems  unreal  or  at  best  of  secondary  importance.  Is  the  criticism 
valid  ? 

As  with  most  questions  of  social  policy,  no  final  and  absolutely 
conclusive  reply  to  this  question  is  likely  to  be  formulated,  for  it 
involves  comparing  the  partly  known  with  the  unknown,  but  we  may 
find  a  basis  for  a  judgment  of  probability  in  regard  to  it.  In  the  first 
place,  it  seems  clear  that  a  limited  amount  of  profit  is  socially  useful, 
indeed  if  we  are  to  continue  the  system  of  individual  enterprise  at  all, 
is  necessary.  For  unless  those  who  place  their  capital  in  a  position 
of  hazard  have  some  hope  of  making  more  than  a  normal  rate  of 
interest,  capital  for  hazardous  investr^nt  cannot  be  expected  to 
appear.  And  in  this  sense  almost  all  new  enterprise  and  much  of  the 
extension  of  old  and  successful  enterprise  through  new  investments 
is  to  be  classed  as  hazardous.  Capital  cannot  all  be  put  at  interest. 
The  existence  of  a  “normal  rate  of  interest”  presupposes  a  guaranteed 
return  on  capital,  and  a  guaranty  on  some  capital  is  impossible 
unless  there  is  other  capital  interposed  between  the  guaranteed 
capital  and  the  hazards  of  the  business. 

It  does  not  follow,  however,  that  because  some  profit  must  be 
anticipated,  it  must  necessarily  be  realized  in  any  given  case,  nor  does 
it  follow  that  the  whole  amount  of  the  return  above  current  interest 
must  even  be  held  up  before  the  prospective  investor  as  a  possible 
reward  for  putting  his  capital  at  risk.  Some  oil  wells  would  doubt¬ 
less  be  drilled  under  a  system  of  taxation  which  confiscated  half  the 
profits  of  the  successful  driller,  without  relieving  him  of  any  of  his 
risk  of  failure,  for  the  rewards  of  success  in  a  limited  number  of 
cases  are  great  enough  to  secure  the  capital,  even  though  the  odds 
against  the  investor  should  be  greatly  increased. 

This  is  the  theory  of  the  excess  profits  tax,  to  permit  a  tax-exempt 
return  high  enough  to  compensate  for  the  use  of  capital  and  take  a 
large  share  of  any  excess,  leaving  the  owner,  however,  some  share 
of  the  excess  return  from  risks  successfully  undertaken  as  an  incentive 
to  his  further  efforts.  The  graduation  of  the  tax,  so  as  to  take  a 
larger  percentage  of  very  high  returns,  while  quite  justifiable  from  the 


SOCIAL  ASPECTS  OF  RISK-BEARING 


357 


standpoint  of  ability  to  pay,  fails  to  take  account  of  the  probability 
that  high  returns  are  associated  with  high  risk.  An  enterprise  offering 
a  high  return  and  a  high  risk,  if  taxed  at  the  same  rate  as  another 
offering  a  low  return  and  a  low  risk,  may  be  equally  attractive,  but 
if  the  unsafe  enterprise  is  taxed  heavily  on  its  successes,  and  gets  no 
compensation  for  its  failures,  more  conservative  investments  are 
encouraged  at  the  expense  of  risky  ones.  An  ideal,  but  probably 
impracticable,  application  of  the  principle  would  involve  the  adjust¬ 
ment  of  the  rate  of  excess  profits  taxation  so  as  to  leave  the  owner  a 
larger  percentage  of  his  profit  in  cases  where  the  risk  appears  in 
<  advance  to  be  larger. 

Interference  with  monopoly  profits  is  quite  practicable  and  from  the 
public  standpoint  desirable. — For  instance,  government  has  largely 
interfered  with  profit  in  the  field  of  public  utility  service,  where  again 
and  again  the  principle  of  a  limited  return  has  been  imposed  in  place 
of  the  principle  of  individual  freedom  in  the  pursuit  of  profits,  and 
industry  has  not  been  stifled.  Here,  however,  it  should  be  noted 
that  the  success  of  the  limitation  has  arisen  from  the  slight  amount  of 
risk  involved  in  the  furnishing  of  public  services  under  conditions  of 
monopoly  coupled  with  steady  and  strong  demand,  and  that  in  the 
fixing  of  a  “fair  return”  due  regard  has  been  given,  in  form  at  least, 
to  the  degree  of  risk. 

In  this  connection  an  interesting  question  arises  relative  to  the 
method  of  calculating  the  investment  upon  which  a  fair  return  is  to 
be  allowed.  Should  the  investor  be  allowed  a  fair  return  upon  the 
amount  he  has  actually  invested  in  the  public  utility  property,  or 
should  his  return  be  figured  upon  the  amount  which  it  would  cost  to 
reproduce  that  property  at  present  price  levels  ?  Both  views  have  had 
numerous  adherents,  although  it  appears  that,  to  a  large  extent,  the 
position  taken  by  advocates  of  both  plans  has  been  determined  by  the 
immediate  situation  rather  than  by  any  well-defined  convictions, 
on  the  principle  involved.  In  a  period  of  rising  prices,  the  friends 
of  the  public  utilities  are  apt  to  be  convinced  that  reproduction  cost 
is  a  very  legitimate  basis  of  calculation,  and  defenders  of  the  public 
interest  to  favor  original  cost,  while  in  periods  of  falling  prices,  opposite 
points  of  view  prevail. 

The  question  is  too  large  a  one  for  complete  discussion  here,  but 
its  connection  with  the  problem  of  risk  reduction  makes  it  necessary 
to  consider  certain  angles  of  it.  The  following  discussion  brings  out 
an  aspect  of  the  problem  which  has  often  been  overlooked: 


35* 


RISK  AND  RISK-BEARING 


An  even  more  serious  objection  to  reproduction  cost,  or  reproduction 
cost  new,  as  it  is  sometimes  called,  is  that  it  tends  when  applied  to  put 
public  utilities  in  the  class  of  speculative  enterprises.  The  valuation  used 
as  a  rate  base,  the  “value”  fixed  by  law  upon  which  earnings  may  be  made, 
when  found  by  this  method  depends,  among  other  things,  upon  the  price- 
level.  If  a  utility  company  can  get  its  property  valued  by  a  commission 
using  this  method  when  prices  are  high  it  may  reap  great  profits  and  at  the 
same  time  conceal  them  from  the  public.  If  the  valuation  be  made  when 
prices  are  low,  the  company  may  suffer  great  loss  and  at  the  same  time 
be  thought  by  the  public  to  be  earning  current  returns  upon  investment. 
Suppose  that  a  utility  company  assembled  its  plant  in  the  late  eighties  of 
the  nineteenth  century,  and  that  a  valuation  was  made  in  1894  or  1895. 
Prices  had  fallen  in  those  years  until  it  would  have  cost  much  less  to 
reproduce  a  plant  than  to  build  it  a  few  years  before.  A  “fair  return” 
upon  the  reproduction  cost  in  1895  would  not  represent  the  current  return 
upon  actual  investment  made  a  few  years  earlier.  Again,  suppose  a  plant 
assembled  in  the  winter  of  1914,  and  that  valuation  by  reproduction  cost 
new  was  made  in  1920.  It  would,  in  1920,  cost  to  reproduce  the  plant  about 
double  the  amount  actually  invested  in  1914.  A  “fair  return”  at  interest 
current  in  1914  upon  such  a  valuation  made  in  1920  would  give  the  investors 
an  enormous  profit.  Let  us  say  that  the  plant  in  1914  cost  $1,000,000. 
Net  earnings  of  6  per  cent  on  the  amount  would  be  $60,000.  In  1920  the 
same  property  could  be  reproduced  or  duplicated  at  about  $2,000,000. 
Six  per  cent  on  this  sum  would  be  $120,000.  But  since  interest  rates  have 
also  advanced,  the  company  might  insist  upon  and  obtain  permission  to 
fix  rates  to  yield  8  per  cent.  Eight  per  cent  on  a  valuation  of  $2,000,000 
would  be  $160,000,  that  is  to  say  16  per  cent  on  the  amount  actually  invested. 
By  this  simple  expedient  of  a  valuation,  made  to  protect  the  public,  the 
public  would  be  called  upon  to  pay  a  return  upon  twice  the  amount  invested 
in  the  property,  to  tax  itself  in  rates  to  give  reality  to  this  estimated  value, 
and  enable  the  owners  to  show  a  commercial  value  double  the  principal 
sum  actually  invested.  Under  a  government  control  making  use  of  repro¬ 
duction  cost  new  to  find  the  value,  the  commercial  value  of  a  utility  property 
would  fluctuate  with  the  rise  and  fall  of  prices.  A  certain  sum  would  be 
put  into  the  property,  but  how  much  the  owners  could  earn  upon  it,  the 
commercial  value  of  their  investment,  would  depend  upon  all  the  complex 
forces  which  are  reflected  in  the  price-level.  How  much  the  investment 
would  be  worth  ten  years  after  it  was  made  would  not  depend  altogether 
upon  honesty  and  ability  of  management  and  confidence  and  support  of 
patrons,  but  even  more  upon  unforeseeable  contingencies,  forces  beyond 
control  of  the  management,  all  those  accidents  in  different  parts  of  the 
world  which  influence  the  movement  of  prices.  Under  such  a  control 
effectively  applied,  an  investor  in  a  public  utility  would  gamble  on  the 
rise  and  fall  of  prices.  Instead  of  utility  properties  attracting  careful 


SOCIAL  ASPECTS  OF  RISK-BEARING 


359 


investors,  they  would  appeal  more  to  that  class  who  speculate  in  mines  and 
oil  propositions.  A  business  owned  by  speculators  is  more  apt  to  be 
“skinned”  for  the  sake  of  immediate  returns,  than  one  owned  by  investors. 
It  is  to  the  public  interest  that  utility  properties  be  owned  by  those  looking 
for  a  moderate  and  regular  return  upon  investment.  In  the  long  run  the 
public  will  get  better  service,  if  the  utility  properties  can  be  developed  so 
as  to  draw  this  class  of  investors.  Reproduction  cost  new  tends  to  defeat 
this  end,  and  to  make'  utility  properties  highly  speculative  ventures.1 

While  the  main  point  in  this  argument  is  well  taken,  it  should  be 
noted  that  the  speculative  element  which  is  introduced  by  the  use  of 
reproduction  cost  is  a  speculative  element  which  is  present  in  all 
ordinary  competitive  business.  If  the  cost  of  building  shoe  factories 
goes  up,  existing  plants  can  presently  charge  prices  based  on  the 
competition  of  newer  factories  built  at  higher  costs,  and  if  the  cost  of 
constructing  such  factories  goes  down  the  older  plants  must  sooner 
or  later  meet  the  competition  of  the  new  low  cost  plants,  even  though 
it  involves  the  writing  off  of  a  large  part  of  their  investment.2 

The  purpose  in  the  use  of  reproduction  cost  is  simply  to  put 
monopolized  business  as  nearly  as  possible  in  the  position  of  competi¬ 
tive  business,  to  gain  for  the  public  the  rates  the  public  would  have  to 
pay  under  conditions  of  competition.  The  case  for  the  use  of  original 
cost,  so  far  as  considerations  of  risk  are  concerned,  must  rest  on  the 
contention  that  it  establishes  a  better  situation  than  would  maintain 
under  competition,  better  both  for  the  investor  and  for  the  public 
because,  while  the  average  result  in  periods  of  rising  and  falling  prices 
taken  together  should  be  the  same,  the  amount  of  uncertainty  would 
be  greatly  reduced  under  the  original  cost  plan.3 

1 W.  M.  W.  Splawn,  “Reproduction  Cost  as  a  Basis  of  Valuation,”  Journal  of 
Political  Economy,  XXIX,  162-63. 

*  It  is  of  course  not  implied  that  the  cost  of  building  factories  is  an  all  sufficient 
explanation  of  a  given  level  of  shoe  prices.  All  that  is  involved  of  price  theory 
is  the  assumption  that  (a)  a  rise  in  building  costs  will  retard  the  construction  of 
factories  till  prices  of  shoes  reach  a  level  which  justifies  such  investment;  ( b )  a 
fall  of  building  costs  will  correspondingly  encourage  building,  so  long  as  shoe  prices 
remain  high,  and  (c)  the  number  of  factories  actually  built  is  a  direct  factor  influen¬ 
cing  the  output  and  hence  the  price  at  which  shoes  can  be  sold. 

s  If  the  difference  between  reproduction  cost  and  original  cost  is  due  to  a  change 
in  the  general  level  of  prices,  the  reproduction  cost  basis  might  lead  to  less  uncer¬ 
tainty.  Cost  of  service  to  the  public  and  return  to  investors  in  dollars  would  fluc¬ 
tuate,  but  the  fluctuation  would  be  offset  by  changes  in  the  purchasing  power  of 
the  dollars. 


360 


RISK  AND  RISK-BEARING 


It  is  dangerous  to  limit  profits  if  risks  are  great. — The  fallacy 
involved  in  reasoning  over  from  monopolistic  to  competitive  condi¬ 
tions  is  well  illustrated  by  the  difficulties  which  have  been  met  recently 
in  controlling  rents.  Within  the  last  few  years,  numerous  attempts 
have  been  made  to  apply  the  principle  of  a  fair  return  on  original 
costs  to  the  rental  of  dwellings,  particularly  apartment  houses,  in  a 
period  when  the  cost  of  construction  had  greatly  advanced.  The 
difficulty  in  applying  this  principle  to  such  an  investment  is  that 
while  the  government  can  restrict  the  investor  to  a  fair  return  on  his 
original  investment  in  a  period  of  advancing  costs,  it  cannot  guarantee 
him  that  return  in  a  period  of  falling  costs,  or  at  least  has  not  proposed 
to  do  so.  Hence,  the  builder  is  confronted  with  the  dilemma  that  if 
prices  advance,  he  will  not  be  allowed  to  increase  rents  above  the 
level  of  a  fair  return  on  his  investment,  while  if  costs  go  down,  he 
will  have  to  meet  the  competition  of  new  buildings  constructed  at  a 
lower  level  and  take  a  loss  as  a  result.  Hence,  the  construction  of 
apartment  houses  has  been  discouraged  by  the  application  of  the 
principle  of  a  fair  return  on  original  cost,  while  the  application  of  this 
principle  in  the  field  of  monopolistic  public  utilities  has  not  had  a 
similarly  discouraging  effect. 

What  is  a  fair  return? — A  question  which  arises  in  connection 
with  the  regulation  of  profit  relates  to  the  allowance  to  be  made 
for  risk.  If  we  are  to  set  limits  to  a  fair  profit,  determining  those 
limits  by  a  consideration  of  the  degree  of  risk  involved,  at  what  time 
is  the  risk  to  be  estimated  ?  Much  of  the  current  discontent  with  the 
profit  system  arises  from  the  obvious  fact  that  the  businesses  which 
are  now  most  profitable  are  being  operated,  to  all  appearances,  with 
a  minimum  of  risk  and,  hence,  with  a  minimum  need  for  managerial 
ability.  An  old  railroad  or  bank  is  an  illustration.  Should  the 
maximum  profit  accrue  to  the  old  established  successful  business, 
whose  managers  have  fewest  risks  to  worry  them?  This  attitude  is 
expressed  by  two  students  of  labor  problems,  as  follows: 

Do  the  owners  and  borrowers  of  capital  assume  all  the  risk?  Profits 
accrue  to  them  today  because  it  is  conceived  that  they  are  the  initiators, 
responsible  agents,  and,  if  necessary,  the  losers  in  industrial  development. 
That  this  is  true  as  a  general  proposition  seems  plausible.  And  in  certain 
fields,  particularly  in  marketing  new  commodities,  there  is  a  risk  that  none 
but  relatively  few  in  the  community  are  willing  to  assume;  and  the  extension 
of  industrial  activities  is  at  present  wholly  dependent  upon  their  assuming 
it.  But  these  cases  can  fairly  be  left  out  of  consideration  because  of  their 
relatively  small  number  in  proportion  to  the  total  production.  Setting 


SOCIAL  ASPECTS  OF  RISK-BEARING 


361 


aside  these  exceptions,  and  viewing  the  problem  as  industry  exists  today— 
not  as  it  has  been  developed  but  as  it  stands  today — the  extent  to  which 
investors  and  enterprisers  in  industry  assume  risk  is  a  matter  as  to  which 
each  case  must  be  considered  separately.  The  risk  is  one  thing  in  a  highly 
competitive  business  where  the  demand  is  new  and  destined  to  rise;  it  is 
another  in  a  monopoly;  it  is  still  another  in  a  declining  business  doomed  to 
disappear.1 

What  is  overlooked  in  this  sort  of  reasoning  is  that  every  old 
conservative  business  was  once  a  new  and  speculative  enterprise, 
and  the  large  and  certain  returns  which  these  old  strong  businesses 
.  now  collect  are  made  possible  by  the  risks  they  have  already  run, 
as  well  as  by  the  risks  others  must  now  run  to  oust  them  from  their 
position.  Should  they  now  be  limited  to  a  fair  return  upon  their 
capital,  they  would  doubtless  continue  to  function,  since  the  capital 
sunk  in  them  cannot  be  recovered  without  loss,  and  since  it  is  now 
exposed  to  comparatively  little  risk.  Once  the  capitalist  has  success¬ 
fully  run  his  risk,  he  is  at  our  mercy,  and  we  can,  if  we  will,  reduce  his 
return  to  correspond  to  the  risks  he  still  has  to  run,  disregarding  those 
that  are  past.  But  can  we  do  this  continuously  and  still  secure  new 
capital  for  enterprises  which  have  yet  to  prove  their  merit?  As 
Professor  W.  H.  Lyon  puts  it: 

How  about  an  established  business?  Should  the  government  be  per¬ 
mitted  to  take  advantage  of  “hindsight,”  and  after  the  event  has  proved 
of  a  business  that  its  promoters  were  justified  in  undertaking  it,  step  in 
and  say  that  the  measure  of  return  shall  be  the  measure  of  risk  now 
apparent  ?  Or  should  the  government  make  what  we  may  call  a  retroactive 
estimate  of  the  risk,  and,  from  the  standpoint  of  the  present,  attemot  to 
measure  the  risk  originally  assumed  ?  Human  judgment  cannot  be  counted 
on  to  be  fair  under  such  circumstances.  It  is  so  easy  now  to  look  baciv  and 
feel  sure  that  the  telegraph,  the  telephone,  the  Union  Pacific  Railway,  in 
fact,  practically  any  established  business,  was  bound  from  the  start  to  be 
successful  in  a  large  way.  Yet  at  the  beginning  of  all  these  things  there 
were  more  thousands  who  believed  that  the  anticipated  profits  did  not 
justify  the  risk  to  be  taken  than  tens  who  believed  that  they  did.  It  is 
impossible  from  the  standpoint  of  the  present  to  get  the  same  view  backward 
that  the  standpoint  of  twenty-five  or  fifty  years  ago  presented  forward. 
It  is  unfair  to  get  the  measure  of  reward  for  a  risk  assumed  in  the  past  by 
a  present  estimate  of  the  risk  now  existing.2 

1  R.  G.  Valentine  and  O.  Tead,  Quarterly  Journal  of  Economics  (February. 
1919),  p.  248. 

'  W.  H.  Lyon,  Corporation  Finance,  pp.  229-30. 


3  62 


SOCIAL  ASPECTS  OF  RISK-BEARING 


Not  only  is  it  unfair,  but  as  a  general  policy  it  seems  certain  to  be 
disastrous,  though  it  may  take  many  years  for  the  evil  results  to 
become  evident.  Nevertheless,  it  does  not  seem  necessary  to  leave 
untouched  every  accumulation  of  profit,  which  either  foresight  or 
good  luck  has  created.  Nor  is  the  question  primarily  one  of  the  size 
of  the  profits.  The  limits  of  social  interference  ( aside  from  monopo¬ 
lies)  depend  chiefly  on  the  question  whether  the  profits  arise  in  a 
way  which  might  reasonably  have  been  anticipated  when  capital  was 
invested ,  or  are  of  an  unpredictable  character.  The  former  cannot  be 
attacked  with  impunity  unless  we  provide  some  other  incentive  to 
capitalists  to  undertake  enterprises  where  there  is  an  appreciable  risk 
of  loss.  The  latter  can  frequently  be  confiscated  or  prevented  without 
such  discouragement  to  future  enterprise,  simply  because  they  are 
recognized  as  being  interferences  of  such  an  exceptional  character  as 
not  to  constitute  a  ground  for  fear  of  similar  interferences  in  the 
future. 

For  example:  if  a  British  importer  of  wheat  is  not  allowed  his 
profit  on  wheat  which  he  has  already  imported  before  the  price  rises 
on  account  of  a  crop  failure  in  Minnesota,  or  a  rise  in  ocean  freight 
rates,  he  is  likely  to  be  deterred  from  making  similar  importations  in 
future  years  when  an  exceptionally  good  harvest  or  a  decline  in  freight 
rates  may  bring  a  loss  from  his  operations.  But  if  an  extremely 
successful  submarine  campaign  cuts  off  a  supply  of  wheat  which  would 
ordinarily  come  into  competition  with  his  importations,  and  forces 
competitive  prices  in  England  to  unheard  of  levels,  government  or 
public  opinion  may  safely  step  in  and  deprive  him  of  his  fortuitous 
gain.  The  chance  of  a  profit  on  account  of  the  change  in  freight  rates 
or  a  change  in  crop  conditions  entered  into  his  calculations  and  will 
enter  into  them  in  the  future.  The  possibility  of  profit  from  the  total 
interruption  of  commerce  with  the  outside  world  did  not  enter  into 
his  calculations  and  will  not  enter  into  his  future  calculations  whether 
he  is  deprived  of  it  on  this  occasion  or  not.  Such  profits  are  free 
gifts,  and  are  at  the  mercy  of  society  to  deal  with  in  such  manner 
as  expediency  in  the  short  run  seems  to  dictate. 

Profiteering  is  collecting  profits  which  are  socially  unnecessary. — 
This  distinction  between  the  cases  where  interference  with  profits 
is  to  be  justified  by  extraordinary  circumstances  and  cases  where  such 
interference  involves,  or  is  likely  to  involve,  an  undermining  of  the 
incentive  to  further  productivity  on  the  part  of  capital,  is  at  the  basis 
of  the  concept  of  profiteering,  of  which  we  have  heard  so  much  in 


RISK  AND  RISK-BEARING  363 

recent  years.  To  understand  this  concept  it  will  be  helpful  to  review 
its  history. 

In  the  medieval  system  of  social  philosophy,  the  place  of  profits 
was  perfectly  defined.  Everything  had  its  “just  price”  and  anyone 
who  made  a  profit  must  do  so  either  by  buying  below  the  “just  price  ” 
or  by  selling  above  it.  Hence,  all  profit  was  illegitimate,  and  the 
middleman  was  necessarily  a  profiteer  and  a  parasite.  Necessarily 
an  exception  to  this  doctrine  was  allowed  in  the  case  of  foreign  trade 
because  it  was  impossible  for  producer  and  consumer  to  meet,  but 
such  trade  was  regarded  as  exceptional.  With  the  development  of 
'  commerce  in  the  later  Middle  Ages,  and  the  increasing  importance  of 
capital  in  manufacture  and  the  great  expansion  of  opportunities  for 
individual  initiative  in  the  early  modern  period,  ‘this  doctrine  of  the 
immorality  of  profits  disappeared.  Public  opinion  swung  to  the  other 
extreme,  and  profit  came  to  be  thought  of  as  the  inevitable,  the  just, 
and  the  socially  beneficial  reward  of  enterprise.  The  “business  man” 
became  the  social  leader. 

With  the  development  of  monopoly  in  numerous  fields  in  the 
latter  part  of  the  nineteenth  century,  the  doctrine  of  the  just  price  was 
partially  revived  in  the  form  of  the  concept  of  a  “fair  return”  to  which 
reference  has  been  made.  Finally,  during  the  Great  War  the  old 
doctrine  reappeared  in  another  form,  the  social  condemnation  of 
excessive  profit-taking  as  profiteering,  and  this  sentiment  found 
expression  in  numerous  types  of  legislation  and  the  other  restrictive 
action  both  in  America  and  Europe.  The  concept,  however,  was, 
and  remains,  an  extremely  vague  one.  Current  literature  abounds 
in  the  denunciation  of  the  profiteer,  but  tests  by  which  he  is  to  be 
distinguished  from  the  wholly  estimable  “successful  business  man” 
are  almost  entirely  lacking. 

Our  ideals  are  changing,  and  change  requires  some  groping  in  the 
dark,  but  the  key  to  the  problem  is  to  be  found  in  the  distinction  drawn 
between  ordinary  profits,  that  is,  profits  which  were,  or  could  have 
been,  anticipated  with  sufficient  clearness  to  constitute  a  motive  for 
venturing  into  a  risky  field  of  investment,  and  extraordinary  profits. 
If  profits  are  attacked  only  rarely,  and  under  color  of  public  necessity, 
or  are  justified  by  their  unusual  size  or  their  extraordinary  origin, 
future  enterprise  may  not  be  discouraged.  If  they  are  confiscated 
persistently  and  as  a  matter  of  public  policy,  some  method  of  pro¬ 
tecting  investors  against  risk  must  be  provided,  or  risky  enterprises 
will  be  avoided. 


364 


RISK  AND  RISK-BEARING 


Must  risk  and  control  be  closely  associated? — In  chapter  iii  the 
effect  of  risk  in  the  distribution  of  wealth  has  been  discussed  on 
the  tacit  assumption  that  the  two  functions  of  carrying  risk  and 
appropriating  profit  are  in  fact  closely  associated  with  a  third,  the 
exercise  of  control.  The  term  owner-manager  was  used  throughout 
the  chapter  instead  of  the  term  entrepreneur ,  generally  used  by  econo¬ 
mists,  in  order  to  keep  this  assumption  from  being  overlooked.  This 
assumption,  which  is  an  original  basic  theory  of  the  modern  type  of 
private  ownership  in  the  means  of  production,  underlies  most  of  our 
law  of  property  and  also  runs  through  most  of  our  orthodox  economic 
theory.  In  fact,  the  whole  modern  organization  of  production  through 
a  separation  of  “entrepreneurs”  from  capitalists  and  laborers  is 
grounded  on  the  assumption  that  the  risk  of  loss  from  any  under¬ 
taking  can  best  be  carried  by  those  who  are  directly  responsible  for 
the  policies  which  may  bring  about  the  loss,  and  conversely  that  the 
responsibility  for  control  can  best  be  exercised  by  those  who  carry 
the  burden  of  risk.  Our  whole  tradition  of  the  right  of  the  individual 
business  manager  to  freedom  from  outside  interference  is  derived 
from  this  conception,  just  as  is  our  traditional  acceptance  of  his 
claim  to  the  entire  profits  of  the  enterprise.  “Whatsoever  a  man 
soweth,  that  shall  he  also  reap,”  is  in  theory  the  essence  of  the  whole 
system  of  private  property  and  free  initiative.  Partly  because  men 
are  believed  to  work  more  efficiently  when  they  themselves  profit 
or  lose  as  their  enterprises  prosper  or  decay,  partly  because  we  have 
felt  it  unjust  for  one  man  to  suffer  from  the  results  of  another’s  mis¬ 
management,  control  of  business  has  been  delegated  to  the  risk¬ 
bearing  factor  rather  than  the  lending  or  laboring  factor  in  the  joint 
enterprise. 

To  a  considerable  extent,  however,  opinion  has  recently  drifted 
away  from  this  point  of  view.  On  the  one  hand  it  is  recognized 
that  the  specialization  of  owners  in  carrying  risk  is  at  best  only  partial; 
that  the  laborer  and  the  capitalist  are  exposed  to  certain  risks  because 
the  entrepreneur  is  unable  to  bear  the  full  amount  of  the  possible  loss. 
Hence,  the  theory  that  control  logically  associates  itself  with  risk  seems 
to  demand  a  partition  of  control  as  a  recognition  of  the  extent  to  which 
risk  is  divided.  For  instance,  the  demand  for  “  industrial  democracy,” 
in  the  sense  of  a  share  for  labor  in  the  management  of  industry,  is  in 
part  a  recognition  of  the  extent  to  which  labor  shares  in  risk.  Like¬ 
wise  the  custom  of  placing  bankers  on  boards  of  directors  of  corpora¬ 
tions  to  whom  the  banks  extend  credit  is  a  recognition  of  the  extent 
to  which  lenders  share  in  risk. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


365 


In  the  next  place,  it  is  recognized  that  there  are  limits  to  the 
extent  to  which  the  bearing  of  risk  carries  with  it  as  a  logical  corollary 
the  actual  assumption  of  control,  for  the  reason  that  the  risk  itself 
may  be  reduced  by  transferring  control  away  from  the  risk-taker  to 
a  hired  manager  whose  greater  expertness  offsets  his  lack  of  direct 
personal  interest  in  his  results.  This  situation,  in  large  part,  accounts 
for  the  tendency  to  increased  complexity  of  organization,  which  has 
accompanied  the  development  of  large-scale  business.  In  small-scale 
business  it  is  still  true  that  most  investors  insist  on  having  either 
control  or  protection  from  the  risk  of  unfortunate  control  by  someone 
else,  but  there  are  many  who  in  large-scale  operations  are  willing  as 
common  stockholders  to  subject  their  capital  to  the  major  risks  of 
business  while  retaining  only  the  merest  shadow  of  control. 

In  legal  theory,  of  course,  the  common  stockholders  are  the 
ultimate  owners  of  the  business,  assuming  the  primary  burden  of 
risk  and  exercising  the  final  control,  but  in  the  case  of  large  corporations 
whose  stock  has  been  distributed  among  investors  the  control  exercised 
by  most  of  these  investors  is  wholly  imaginary.  Actually  the  control 
is  exercised  by  the  relatively  small  group — officers,  creditors,  or  active 
stockholders,  who  are  interested  enough  and  have  ability  enough  to 
exercise  it,  and  the  results  of  the  control  exercised  by  this  group  fall 
only  slightly  on  themselves.  The  investor’s  reliance  is  primarily 
on  their  good  faith  and  ability  as  witnessed  by  past  performance, 
not  on  any  close  association  between  the  control  and  its  consequences. 

One  important  result  of  this  dissociation  between  control  and  risk 
has  been  the  wide  spread  of  the  practice  of  limited  liability.  An 
investor  does  not  hesitate  to  intrust  a  definite  sum  of  capital  to 
another’s  control,  but  he  will  rarely  accept  the  full  responsibility  of 
ownership  in  an  enterprise,  with  resulting  liability  for  its  debts, 
unless  he  has  a  real  voice  in  its  management.  Hence  for  enterprises 
too  large  to  be  financed  by  those  who  actually  control  them,  the 
corporation  and  the  limited  partnership  are  devised.  The  investor 
in  stock  limits  his  liability  to  the  amount  he  actually  invests,  or  to  a 
stipulated  sum  in  excess  thereof.  The  risk  of  which  he  divests  himself 
by  this  means  is  scattered  among  the  creditors.1 

‘Texts  in  elementary  economics  sometimes  contain  the  question:  “In  a  cor¬ 
poration,  who  is  the  entrepreneur?”  It  may  not  be  amiss,  therefore,  at  this  point, 
to  call  attention  to  the  impossibility  of  applying  the  concept  “entrepreneur”  to 
any  part  of  a  corporate  organization  (except  in  a  close  corporation  which  is  managed 
like  a  partnership).  The  essence  of  entrepreneurship  is  the  union  of  control  and 
risk-bearing;  in  a  public  corporation  these  are  not  united 


366 


RISK  AND  RISK-BEARING 


Another  modification  of  our  traditional  policy  of  uniting  control 
and  risk  is  found  in  the  numerous  safeguards  which  have  been  erected 
for  the  protection  of  debtors.  Bankruptcy  laws,  exemption  of  home¬ 
steads,  of  the  proceeds  of  insurance  policies,  of  the  tools  of  a  trade, 
and  of  minimum  earnings  from  attachment  for  debt,  all  are  ways  of 
transferring  part  of  the  risk  of  business  from  the  owner-manager  to 
his  creditors,  in  recognition  of  the  fact  that  the  enterprise  is  in  fact  a 
co-operative  one,  in  which  all  have  an  interest  and  in  the  results  of 
which  all  may  be  required  to  share,  if  a  strict  enforcement  of  the  full 
responsibility  of  the  owner-manager  results  in  hardship. 

The  test  of  a  wise  social  policy  in  this  matter  seems  to  be  much 
the  same  as  in  the  converse  case  of  limitation  of  profits,  to  which 
reference  was  made  above  (pp.  362-63).  What  is  the  effect  on 
incentive?  The  object  of  placing  the  responsibility  on  business 
men  for  loss  of  property  intrusted  to  them  by  their  creditors  is  to 
secure  a  maximum  of  interest  and  effort  on  their  part  and  to  induce 
lenders  to  part  with  their  capital;  if  the  proposed  interference  follows 
such  exceptional  circumstances  that  it  will  not  enter  seriously  into  the 
calculations  of  lenders  or  business  men,  and  either  retard  the  financing 
business  or  lead  to  wasteful  management,  it  may  be  judged  by  its 
immediate  value  in  relieving  distress;  if  it  extends  to  normally 
anticipated  situations  it  will  probably  do  more  harm  than  good. 

President  David  Friday  has  made  an  interesting  suggestion  looking 
to  the  elimination  of  the  waste  incident  to  the  curtailment  of  produc¬ 
tion  for  business  reasons,  especially  in  times  of  failing  prices.1  He 
proposes  that  the  government  should  establish  an  insurance  fund  to 
protect  business  men  from  the  loss  of  their  capital. 

His  argument,  in  brief,  is  as  follows:  The  recurrent  curtailment 
of  production  by  business  managers  is  to  be  explained  primarily  in 
terms  of  fear  of  loss  rather  than  greed  for  high  profits.  Business  men 
are  willing  to  continue  operation  of  their  enterprises  at  times  when 
the  prospect  of  profit  is  small,  provided  they  do  not  by  so  doing  incur 
too  great  a  risk  of  loss.  To  insure  to  each  entrepreneur  his  actual 
costs,  obtaining  the  necessary  funds  by  taxation  of  successful  businesses, 
would  remove  the  incentive  to  stop  production,  and  thereby  prevent 
wastes  of  such  enormous  magnitude  as  would  more  than  compensate 
for  the  social  costs  of  administration. 

1  “Maintaining  Productive  Output,”  Journal  of  Political  Economy,  XXVII 
(January,  1919),  117-26. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


367 


Into  the  administrative  difficulties  involved  in  this  proposal  we 
shall  not  carry  our  criticism.  The  social  waste  of  underproduction 
(estimated  by  President  Friday  at  $10,000,000,000  per  annum)  is 
large  enough  to  justify  vast  expenditure  on  any  experiment  which  offers 
a  reasonable  chance  of  success  in  eliminating  it.  We  can  even  afford 
to  face  the  certainty  of  numerous  individual  cases  of  abuse,  if  the 
general  result  is  to  increase  the  national  dividend  by  half  of  the  sum 
involved. 

More  fundamental  than  the  administrative  difficulty,  however, 
is  the  question  of  the  ultimate  social  gain  to  be  derived  from  the 
operation  of  the  scheme,  assuming  that  the  difficulties  of  administra¬ 
tion  were  overcome.  Proposals  to  relieve  the  business  man  from  the 
risk  of  losing  his  out-of-pocket  costs  assume  that  these  risks  have  no 
social  value;  are  they  not  on  the  contrary  as  essential  in  maintaining 
a  proper  balance  in  production  as  are  the  hopes  of  profit  ?  It  is  quite 
true  that  it  is  the  fear  of  loss  rather  than  the  smallness  of  profit  that 
induces  the  suspension  of  production  in  periods  of  falling  prices  and 
diminishing  demand,  but  such  curtailment  is  a  belated  recognition 
that  production  in  certain  lines  has  gone  too  far.  The  elimination  of 
the  risk,  would,  it  appears,  tend  to  aggravate  the  tendency  to  follow 
the  lure  of  immediate  profit  by  producing  to  excess  those  commodities 
of  which  at  the  preceding  moment  there  has  seemed  to  be  a  deficit. 

For  example,  it  is  now  perfectly  clear  that  at  the  close  of  1919 
the  world  had  been  producing  too  much  of  certain  perishable  consump¬ 
tion  goods,  notably  sugar,  textiles,  and  rubber  tires,  and  not  enough 
of  such  durable  goods  as  houses,  street  cars,  and  bridges.  This  is 
the  natural  tendency  of  production  at  times  when  it  is  anticipated 
that  over  a  long  period  the  tendency  of  prices  will  be  downward. 
Men  are  willing  to  pay  high  prices  for  the  goods  which  they  buy  for 
the  immediate  future,  but  balk  at  paying  peak  prices  for  permanent 
construction.  Everyone  recognized  that  the  nation  was  understocked 
with  buildings  and  public  utility  properties,  long  before  it  was  clear 
that  it  was  overstocked  with  perishables.1 

When  the  latter  fact  became  clear,  production  slackened,  in  the 
one  field,  then  gradually  revived  in  the  other.  If  the  result  of  a 

1  It  is  not  implied  that  this  was  the  only  factor  involved.  Another  factor,  for 
instance,  was  the  great  difficulty  in  getting  higher  prices  out  of  the  public  for  such 
staple  necessities  as  transportation,  rent,  and  gas.  It  does  not  appear  likely  that 
this  situation  would  have  been  alleviated  by  public  knowledge  that  the  corpora¬ 
tions  and  individuals  furnishing  these  necessities  were  protected  by  insurance 
against  business  losses. 


368 


RISK  AND  RISK-BEARING 


guaranty  of  costs  would  have  been  to  divert  productive  energy  sooner 
from  the  field  that  was  overdone  to  the  neglected  field,  a  great  national 
gain  would  have  resulted  from  its  adoption.  It  is  clear  that  this  would 
not  have  been  true,  however.  As  things  actually  stood  till  the  end 
of  1919,  the  risk  of  producing  sugar  seemed  less  than  that  of  producing 
street  cars;  if  this  risk  had  been  removed  by  social  insurance  it  would 
still  have  been  true  that  the  prospective  profit  of  producing  perishables 
would  have  been  greater  than  that  of  producing  durables.  Might 
not  the  result  of  insurance  of  costs  have  been  to  prolong  the  maladjust¬ 
ment  by  removing  the  fear  that  actually  brought  about  the  readjust¬ 
ment,  leaving  us  with  a  still  greater  overstock  of  sugar  and  understock 
of  trolley  cars  when  the  readjustment  finally  came  ? 

Insurance  of  costs  seems  to  look  to  the  immediately  disastrous 
effects  of  readjustment  of  malproduction;  a  sound  social  policy 
should  look  to  a  prevention  of  the  maladjustment,  and  in  the  author’s 
opinion,  is  to  be  secured  rather  through  the  development  among 
business  men  of  an  appreciation  of  the  risks  involved  in  following 
blindly  the  guidance  of  prices,  advance  orders  and  profit  margins, 
rather  than  through  the  elimination  of  those  risks. 

The  interest  of  society  is  not  merely  to  secure  the  maximum 
expenditure  of  energy  by  productive  agents;  it  is  to  direct  those 
agents  to  the  creation  of  the  goods  which  satisfy  a  real  need,  and  it 
does  not  seem  probable  that  the  assumption  by  a  government  agency 
of  the  risk  of  loss,  leaving  undisturbed  the  forces  which  fix  the  relative 
profit  margins  in  various  lines  of  business,  will  notably  improve  the 
apportionment  we  now  secure.  For  it  will  very  frequently  be  true 
that  the  line  of  activity  which  seems  to  offer  a  prohibitive  risk  of 
loss,  and  therefore  is  neglected,  will  also  offer  the  minimum  opportunity 
of  profit,  and  therefore  be  neglected  even  though  the  risks  are  /emoved. 
Such  an  arrangement  would  favor  the  highly  speculative  undertaking, 
by  giving  the  entrepreneur  a  chance  at  a  very  high  profit  without  a 
corresponding  risk  of  loss;  otherwise  it  is  not  clear  that  it  would  have 
any  marked  effect  on  the  distribution  of  social  energy. 

Finally,  the  effect  of  subjecting  investment  and  operation  to  such 
a  degree  of  public  control  as  the  insurance  program  would  involve  is 
dubious.  President  Friday  believes  that  the  government  would 
refuse  to  permit  suspension  of  operation  and  consequent  unemploy¬ 
ment  if  it  were  in  the  position  of  a  guarantor  of  cost;  is  it  not  on  the 
other  hand  probable  that  the  insurance  bureau  would  be  inclined  to 
demand  the  suspension  of  production  whenever  it  appeared  probable 


SOCIAL  ASPECTS  OF  RISK-BEARING  369 

that  such  operation  would  result  in  loss,  thereby  aggravating  the  evil 
against  which  a  remedy  is  sought  ? 

II.  THE  ETHICS  OF  GAMBLING 

An  estimate  of  the  social  significance  of  the  group  of  institu¬ 
tions  through  which  the  transfer  of  risks  is  accomplished  may  con¬ 
veniently  proceed  by  a  consideration  of  certain  aspects  of  gambling, 
of  insurance,  and  of  speculation.  These  three  types  of  activity  have 
this  much  in  common,  that  all  consist  of  the  transfer  of  wealth  from 
one  person  to  another  in  a  way  which  is  contingent  upon  an  un¬ 
known,  usually  a  future,  event.  Between  a  short  sale  of  wheat  and 
a  bet  that  the  price  of  wheat  will  fall,  or  between  a  fire  insurance 
policy  and  a  bet  that  a  certain  house  will  burn,  there  is  superficially 
a  close  resemblance;  an  analysis  of  the  difference  between  them 
must  get  back  of  the  form  to  the  social  and  individual  consequences. 

In  chapter  vii,  we  gave  attention  to  opportunities  of  profit  involved 
in  gambling,  without  consideration  of  the  social  and  moral  aspects 
of  the  question.  It  remains  to  consider  the  justification  of  the  tra¬ 
ditional  condemnation  of  gambling  as  immoral.  Is  it  purely  a  ques¬ 
tion  of  balancing  the  risk  of  loss  against  the  individual’s  enjoyment 
of  the  excitement,  or  are  there  more  important  social  considerations  ? 
The  following  points  are  suggested  as  having  a  bearing  upon  our  answer : 

a)  The  gambler  is  in  an  antisocial  position. — The  whole  drift  of 
social  evolution  throughout  the  recorded  history  of  the  race  has  been 
toward  the  development  of  moral  standards,  of  legal  and  political 
institutions,  and  of  other  agencies  of  social  control  to  enforce  co-opera¬ 
tion;  that  is,  to  induce  or  compel  the  individual  to  seek  his  own 
advancement  through  activities  which  tend  to  the  advancement 
of  other  members  of  his  group.  The  gambler,  however,  gains  only  as 
others  lose.  The  traditional  attitude  of  hostility  toward  the  gambler 
rests,  therefore,  on  much  the  same  ground,  though  its  expression  is 
less  extreme,  as  our  hostility  toward  the  confidence  man  and  the 
burglar.  The  more  efficient  any  of  these  become,  the  poorer  the  rest 
of  the  world  becomes,  and  the  more  surely  the  rest  of  the  world  must 
organize  to  restrain  the  antisocial  activity. 

b)  Energy  devoted  to  the  improvement  of  the  gambler's  technique  is, 
socially  speaking,  wasted. — A  universal  energizing  of  gamblers  or  a 
general  introduction  of  scientific  management  among  them  would 
leave  them  and  the  world  no  better  off,  for  one  gambler’s  gain  in 
efficiency  would  be  offset  by  another’s.  In  this  respect  the  gambler’s 


370 


RISK  AND  RISK-BEARING 


position  is  analogous  to  that  of  the  militarist,  the  political  stump 
speaker,  and  the  proselyting  apostle.1 

c)  Gambling  tends  to  disqualify  one  for  work. — On  the  one  hand  the 
successful  gambler  finds  money  coming  so  easily  through  the  pursuit 
of  chance  that  it  seems  a  waste  of  time  and  energy  to  hammer  out  an 
income  by  the  slow  and  painful  processes  by  which  most  of  the  world 
makes  its  living.  On  the  other  hand,  the  unsuccessful  gambler  finds 
the  fruits  of  his  labor  slipping  away  from  him  and  becomes  discouraged 
and  is  apt  to  pin  his  fate  to  a  turn  in  luck  rather  than  to  a  return  to 
productive  employment.  So  long  as  the  world’s  business  cannot  be 
conducted  without  work,  any  institution  which  tends  to  reduce  the 
number  of  competent  workers  is  socially  undesirable.  In  this  respect 
gambling  is  comparable  to  the  institution  of  inheritance.3 

d)  The  sum  total  of  gambling  transactions  involves  a  net  social  loss , 
for  it  tends  to  increase  inequality  of  wealth,  and  unequal  distribution 
of  wealth  decreases  its  utility.  Suppose  A  and  B  bet  counters  on  the 
toss  of  a  fairly  balanced  coin.  If  they  play  a  long  time  the  most 
probable  theoretical  result  is  that  they  win  the  same  number  of  tosses 
and  quit  as  they  began.  But,  if  the  number  of  counlers  they  hold  is 
small,  the  chances  are  that  before  they  toss  a  thousand  times  one  of 
them  will  be  out  of  counters  and  the  game  will  stop.  If  they  start 
even  it  is  of  course  as  likely  that  one  will  survive  as  the  other,  but  if 
one  has  more  counters  than  the  other  the  game  is  loaded  in  his  favor. 
If  A,  for  instance,  starts  with  ioo  counters  and  B  with  io,  the  chances 
are  that  before  they  make  a  thousand  tosses  B  will  run  out  of  counters 
and  have  to  quit.  If  he  has  to  reserve  some  of  his  counters  for  some 
other  purpose,  he  is  so  much  the  more  certain  to  quit  a  loser,  though 
his  loss  will  not  be  so  great.  If  he  reduces  his  stakes  when  his  fund 
begins  to  get  low  and  increases  them  as  it  grows,  as  he  is  very  likely 
to  do,  the  odds  are  against  him  still  more,  for  every  run  of  luck  against 

1  These  analogies  are  of  course  imperfect,  for  the  increased  zeal  and  efficiency 
of  rival  propagandists  does  tend  to  bring  out  the  truth,  however  much  they  may 
as  individuals  seek  to  obscure  it. 

aFor  more  emphatic  statement  of  this  point  cf.  “The  Social  Evil,”  Outlook , 
June  28,  1912,  p.  246.  “Gambling  likewise  isolates  the  risk  and  excitement  that 
are  found  as  an  element  in  all  legitimate  enterprise;  and  by  artificial  devices  pro¬ 
vides  for  the  constant  recurrence  of  that  excitement  apart  from  any  useful  work  or 
worthy  undertaking.  Nature  retaliates  by  taking  from  the  man  who  tries  to  cheat 
her  the  inclination  and  the  power  of  steady  industry;  the  true  sense  of  social  value; 
and  makes  of  him  a  burden  to  his  family,  an  irritable  and  worthless  parasite  upon 
the  industrial  order.” 


SOCIAL  ASPECTS  OF  RISK-BEARING 


371 


him  will  have  to  be  made  up  by  a  longer  run  in  his  favor,  while  a  run 
in  his  favor  will  be  wiped  out  by  a  shorter  run  against  him. 

This  is  probably  the  most  important  reason  for  the  very  large 
percentage  of  failures  not  only  in  gambling  but  in  all  speculative 
enterprises  where  the  duration  of  the  individual  transaction  is  short 
and  the  scale  of  operations  can  be  increased  readily.  For  instance, 
note  the  cases  in  industry  and  trade  in  which  one  year  of  depression 
has  taken  away  the  profits  of  several  years  of  prosperity.  The 
expansion  of  operations  made  possible  by  the  war  profits  makes  the 
scale  of  losses  on  the  way  down  bigger  than  the  scale  of  profits  on 
the  way  up. 

e)  A  perfectly  fair  gamble  is  bad  economics. — Say  A,  having 
$1,000  stakes  $100  against  $100  on  a  fair  and  legitimate  1:1 
chance.  He  is  balancing  the  chance  of  increasing  his  fortune  to 
$1,100  against  the  chance  of  reducing  it  to  $900.  But  in  accordance 
with  what  economists  call  the  “law  of  diminishing  utility,”  he  will 
lose  more  if  his  wealth  is  cut  to  $900  than  he  will  gain  if  it  is  increased 
to  $1,100,  for  the  tenth  hundred  provides  for  more  urgent  needs  or 
wants  than  does  the  eleventh.  So  with  each  addition  to  one’s  wealth. 
The  more  he  has,  the  less  the  importance  of  one  more  unit;  the 
unit  the  gambler  may  lose  is  of  greater  importance  than  the  one  he 
may  win. 

The  larger  the  unit  staked  in  proportion  to  the  total  owned,  the 
more  important  this  point  becomes.  Loss  of  one’s  entire  fortune 
causes  a  far  more  important  change  of  status  than  does  doubling  it. 
On  the  other  hand,  if  the  unit  staked  is  relatively  small  the  point  is  of 
no  importance.  The  difference  between  the  utility  of  the  999th  and 
that  of  the  1, oooth  dollar  is  entirely  negligible.  Indeed,  in  some  cases 
the  argument  may  be  turned  the  other  way.  Suppose  A  buys  a 
lottery  ticket  for  ten  cents,  which  gives  him  one  chance  in  5,000  of 
winning  $500.  Mathematically  the  bet  is  an  even  one;  economically  it 
may  be  in  his  favor,  for  the  dime  he  will  probably  lose  represents  no 
perceptible  impairment  of  his  capital  or  lowering  of  his  income,  while 
the  prize  he  may  possibly  win  will  bring  him  a  perceptible  benefit. 
This  will  hold  even  if  he  pays  fifteen  cents  for  the  ticket.  The  bar¬ 
gain  is  now  a  good  one  for  both  the  buyer  and  the  seller  (indirect 
moral  and  social  losses  being  disregarded).  The  lottery  thus  affords 
a  means  of  collecting  from  a  great  number  of  persons  amounts  so  small 
that  their  psychological  cost  is  negligible  and  combining  them  into 
units  large  enough  to  give  a  few  people  a  perceptible  addition  to  their 


372 


RISK  AND  RISK-BEARING 


material  welfare.  The  advantage  of  this  sort  of  gamble  to  the  buyer 
of  the  small  chance  depends  on  his  rigidly  limiting  not  only  the  size 
but  the  number  of  his  purchases  to  such  an  extent  that  the  loss,  which 
is  overwhelmingly  probable,  will  mean  nothing  in  his  standard  of 
living.  This  is  very  difficult  to  do,  but  if  he  succeeds  the  real  odds  are 
distinctly  in  his  favor. 

/)  Nothing  that  has  been  said  should  be  applied  to  the  case  of  the 
professional  gambling-house  keeper.  He  is  not  necessarily  a  gambler 
at  all;  he  is  a  business  man  selling  entertainment  and  taking  his  pay 
through  a  percentage  in  his  favor  in  the  arrangement  of  odds.  His 
risk  is  not  the  gambling  risk  at  all,  it  is  the  risk  common  to  all  lines 
of  business  of  failing  to  get  enough  business  to  cover  overhead  costs, 
with  the  added  necessity  of  getting  a  certain  volume  in  order  to  insure, 
the  working  of  the  law  of  averages  on  which  he  depends  for  his  income. 

g)  Against  these  clear  costs  and  dangers  of  gambling  there  can 
be  set  simply  the  fact  that  a  very  large  proportion  of  the  race  in  all 
ages  have  found  it  enjoyable,  and  have  been  willing  to  pay  the  cost  of 
supporting  an  expensive  body  of  devices  and  organizations  to  enable 
them  to  gratify  their  taste  for  this  form  of  excitement.  The  foregoing 
of  this  enjoyment  may  be  a  necessary  part  of  the  cost  of  building  an 
organization  in  which  men  can  live  together  with  the  minimum  fric¬ 
tion  and  maximum  satisfaction,  but  it  is  none  the  less  a  cost. 

In  summary:  the  moral  condemnation  of  gambling  must  rest 
not  on  its  economic  irrationality,  for  it  may  in  many  cases  be  defended 
as  rational,  either  on  the  ground  that  the  stake  is  so  small  as  to  involve 
no  real  loss,  or  on  the  ground  that  the  amusement  is  worth  the  cost. 
The  final  condemnation  or  indorsement  of  this  practice  must  rest  on 
our  judgment  of  the  importance  of  the  effects  it  produces  on  men’s 
ability  and  willingness  to  co-operate  in  the  building  and  maintenance 
of  a  better  social  structure. 

In  the  author’s  opinion,  the  weight  of  the  argument  rests  with  the 
opponents  of  gambling;  the  traditional  condemnation  of  the  practice 
as  immoral  reflects  a  sound  judgment  of  the  social  issues  at  stake. 
Whether,  however,  gambling  belongs  in  the  list  of  immoralities  which 
an  intelligent  social  policy  seeks  to  prohibit  by  legal  enactment,  or 
whether  it  is  one  of  the  far  more  numerous  types  of  antisocial  conduct 
which  can  more  wisely  be  discouraged  by  education  and  moral  suasion 
only,  is  an  entirely  different  question.  Any  attempt  to  answer  this 
question  would  take  us  too  far  from  the  field  of  the  present  study,  into 
considerations  of  the  limits  of  effective  coercion  in  human  conduct. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


373 


III.  THE  ETHICS  OF  INSURANCE 

As  was  stated  above,  an  insurance  contract  is  not  dissimilar  in 
form  to  a  wager.  The  insured  pays  a  small  premium,  which  he  may 
lose  or  may  receive  again  multiplied  many-fold,  in  accordance  with 
the  outcome  of  an  uncertain  event.  But,  though  the  form  is  the  same, 
the  moral  aspects  of  the  question,  provided  a  genuine  risk  is  insured, 
are  exactly  opposite.  The  insurance  contract  serves  to  decrease  risk, 
to  substitute  a  small  but  certain  loss  for  a  large  uncertain  one.  Thus  a 
net  gain  results,  parallel  to  the  net  loss  involved  in  a  gambling  con¬ 
tract.  We  noted  above  that  a  perfectly  fair  gamble  is  economically 
unsound  for  the  reason  that  the  gain,  if  one  wins,  is  smaller  than  the 
loss  if  he  loses,  because  of  the  operation  of  the  principle  of  diminishing 
utility.  The  case  of  the  insurance  contract  is  just  the  opposite. 
Ignoring  insurance  company  expenses  and  profits,  let  us  assume  that 
A  pays  $10  for  $1,000  of  fire  insurance,  knowing  that  the  chance  of 
his  suffering  a  loss  of  $1,000  is  exactly  T^.  Mathematically,  his 
bargain  is  neither  good  nor  bad;  economically,  it  is  good  because  the 
$1,000  he  may  lose  represents  more  in  real  sacrifice  than  one  hundred 
times  the  loss  of  the  $10  involved  in  the  payment  of  the  premium. 

Likewise  most  of  the  other  arguments  advanced  in  the  preceding 
section  to  show  the  antisocial  character  of  gambling,  have  no  applica¬ 
tion,  or  a  negative  application,  to  insurance  which  covers  a  genuine 
risk.  Neither  the  insurer  nor  the  insured  puts  himself  in  a  position 
where  his  gain  depends  on  the  other’s  loss;  rather  they  have  a  common 
interest  in  the  non-occurrence  of  the  event  insured  against.  Energy 
devoted  to  the  improvement  of  the  insurance  technique  is  not  wasted, 
as  is  energy  devoted  to  the  improvement  of  the  gambling  technique; 
insurance  does  not  tend  to  disqualify  one  for  work,  but  rather  encour¬ 
ages  one  to  labor  in  the  confidence  that  he  will  not  be  deprived  of  the 
fruits  of  his  labors  by  some  accidental  circumstance;  insurance  does 
not  tend  to  create  inequality  of  wealth. 

On  the  other  hand,  whenever  there  is  no  genuine  risk  to  be  hedged, 
as  is  the  case  in  overinsurance,  and  in  the  case  of  insurance  on  the  life 
of  persons  who  have  no  producing  power,  the  arguments  cited  against 
gambling  have  full  force.  The  following  account  of  the  early  history 
of  life  insurance  illustrates  the  possibility  of  using  the  insurance  con¬ 
tract  for  purely  gambling  purposes. 

The  distinguishing  feature  of  the  age  was  the  “Gambling”  tendency  of 
nearly  all  the  Offices.  Under  the  title  of  “Insurance  Wagers,”  every  con¬ 
ceivable  description  of  speculation  was  entered  into.  The  duration  of  the 


374 


RISK  AND  RISK-BEARING 


lives  of  persons  believed  to  be  on  their  death-bed,  was  a  common  hazard, 
and  the  author  of  Every  M an  His  Own  Brother  was  not  far  wrong  when  he 
said  the  dissolution  of  persons,  who  saw  themselves  insured  in  the  public 
papers  at  90  per  cent,  was,  not  unlikely,  hastened  by  such  announcements. 

Even  the  morality  of  the  newspapers  of  that  day  was  shocked  by  such 
proceedings;  we  find  the  London  Chronicle  of  1768  thus  declaiming,  “The 
introduction  and  amazing  progress  of  illicit  gaming  at  Lloyd’s  Coffee-house 
is,  among  others,  a  powerful  and  very  melancholy  proof  of  the  degeneracy 
of  the  time.  Though  gaming  in  any  degree  is  perverting  the  original  and 
useful  design  of  that  Coffee-house,  it  may  in  some  measure  be  excusable  to 
speculate  on  the  following  subjects: — Mr.  Wilkes  being  elected  member  for 
London:  which  was  done  from  5  to  50  guineas  per  cent.: — Mr.  Wilkes  being 
elected  member  for  Middlesex,  from  20  to  70  guineas  per  cent.;  Alderman 
Bond’s  life  for  one  year,  now  doing  at  7  per  cent.: — On  Sir  J.  H.  [mark  the 
modesty!]  being  turned  out  in  one  year,  now  doing  at  12  guineas  per  cent.; 
— On  John  Wilkes’  life  for  one  year,  now  doing  at  five  per  cent.  N.B. 
Warranted  to  remain  in  prison  during  that  period: — On  a  declaration  of  war 
with  France  of  Spain  in  one  year,  8  guineas  per  cent.”  “But,”  continues 
the  sensitive  journalist,  “when  policies  come  to  be  opened  on  two  of  the 
first  peers  in  Britain  losing  their  heads  at  10s.  6d.  per  cent,  or  on  the  dissolu¬ 
tion  of  the  present  parliament  within  one  year  at  5  guineas  per  cent.,  which 
are  now  actually  doing,  and  underwritten  chiefly  by  Scotsmen,  at  the  above 
Coffee-House,  it  is  surely  high  time  to  interfere.” 

In  the  Public  Advertiser  of  Dec.  6,  1771  [then  the  leading  newspaper], 
we  find  the  following  paragraph: — “We  have  the  pleasure  to  assure  the  pub¬ 
lic,  from  the  most  undoubted  authority,  that  the  repeated  accounts  of  her 
Royal  Highness  the  Princess  Dowager  of  Wales  being  very  ill,  and  her  life 
in  great  danger,  are  entirely  false;  such  reports  being  only  calculated  to  pro¬ 
mote  the  shameful  spirit  of  the  gambling  by  insurance  on  lives!”1 

IV.  THE  ETHICS  OF  SPECULATION 

The  case  for  organized  speculation  is  midway  between  that  for 
insurance  and  that  for  gambling.  The  speculative  contract  which 
transfers  to  speculators  the  risk  which  some  one  must  carry  anyway 
is  analogous  to  insurance  in  that  it  relieves  one  party  of  risk  and  enables 
him  to  do  business  more  economically  and  efficiently.  It  is  inferior 
to  insurance  in  that  the  insurer  does  not  as  a  rule  get  rid  of  the  risk 
by  combination.  The  total  amount  of  uncertainty-bearing  is  not 
reduced,  but  the  incidence  is  shifted  to  those  who  voluntarily  elect 
to  carry  it.  Incidentally,  as  was  noted  in  chapter  xi,  the  service  of 

1  Walford,  Insurance  Guide  and  Handbook ,  pp.  27-28.  (4th  ed.;  Charles  & 
Edwin  Layton,  London,  1901.) 


SOCIAL  ASPECTS  OF  RISK-BEARING 


375 


risk-bearing,  so  far  as  the  whole  group  of  speculators  are  concerned, 
is  probably  uncompensated,  so  that  society  as  a  whole  gains  at  the 
expense  of  the  speculative  group. 

If  the  personnel  of  the  futures  market  were  made  up  entirely  of 
hedge  buyers  and  sellers,  it  would  not  be  a  speculative  market  at  all; 
it  would  be  simply  a  convenient  device  by  which,  on  the  one  hand, 
industries  using  grain  or  cotton  as  raw  materials,  and,  on  the  other 
hand,  dealers  in  those  commodities,  could  trade  with  one  another,  the 
needs  of  the  one  group  for  protection  against  falling  prices  being  offset 
by  the  need  of  the  other  group  for  protection  against  rising  prices. 
Unfortunately,  the  needs  of  dealers  in  raw  materials  and  those  of 
manufacturers  who  need  to  buy  hedges  do  not  coincide  in  time  nor 
necessarily  in  volume.  Consequently,  a  futures  market  without 
speculators  could  only  be  run  through  some  such  process  as  this,  that 
if  at  a  given  season  there  was  an  excess  of  supply  of  hedging  contracts 
from  producers  of,  or  dealers  in,  the  raw  materials,  over  the  number 
required  as  hedging  purchases  by  manufacturers,  the  price  would  be 
forced  so  low  that  manufacturers  would  be  induced  to  contract  in 
advance  for  their  supplies  of  raw  material,  thus  taking  the  load  off 
the  market.  Vice  versa,  if  there  were  an  excess  of  demand  for  hedges 
from  industries  and  a  consequent  high  price,  prospective  sellers  of 
hedges  might  be  induced  to  sell  their  contracts  in  advance.  Such 
a  development  would  not  mean  the  elimination  of  the  speculator 
however;  it  would  merely  mean  that  dealers  and  manufacturers  had 
been  given  an  inducement  to  become  speculators  themselves.  To  a 
large  extent,  something  like  this  does  happen,  but  it  is  not  at  all  clear 
that  there  is  any  social  advantage  in  having  the  speculating  done  by 
people  who  are  also  dealers  in  raw  material  or  products  rather  than 
by  specialists  in  speculation.  Certainly  the  presence  of  a  group  of 
speculative  traders  who  are  ready  on  occasion  to  take  either  side  of 
the  market,  facilitates  the  hedging  process  by  making  the  market 
broad  and  continuous  enough  30  that  the  hedger  is  able  to  make  his 
trades  with  confidence  that  a  contract  once  opened  can  be  closed  out 
again  without  breaking  or  “bulling”  the  market.  As  a  practical 
issue,  there  can  be  no  hedging  without  speculation. 

It  is  undoubtedly  true,  however,  that  in  a  large  number  of  trades 
neither  party  is  hedging;  there  are  only  two  speculators,  one  trading 
for  a  rise  and  the  other  for  a  fall.  If  all  the  trades  were  of  this  char¬ 
acter,  the  social  results  would  be  exactly  the  same  as  those  outlined 
in  the  case  of  gambling  contracts.  There  is  in  speculation  the  same 


376 


RISK  AND  RISK-BEARING 


unwholesome  dissociation  of  income  from  useful  work  as  in  gambling; 
the  same  consequent  undermining  of  the  sense  of  the  values  of  money 
and  of  work;  the  same  eagerness  to  profit  by  another’s  misfortunes; 
and  the  same  temptation  to  risk  more  than  one  can  afford  to  lose,  and 
to  seek  to  recoup  one’s  fallen  fortunes  by  dishonest  means. 

The  question  whether  a  speculative  market  serves  to  increase  or 
decrease  the  net  amount  of  uncertainty  resolves  itself  into  a  question 
concerning  the  proportion  of  trades  which  are  purely  speculative  in 
character.  No  data  bearing  directly  on  this  question  are  available, 
but  the  indirect  evidence  indicates  that  a  very  large  part  of  the  trades 
on  the  American  exchanges  are  purely  speculative.1  But  it  must  be 
remembered  that  a  hedging  trade  may  be  made  between  two  specu¬ 
lators,  neither  of  whom  has  any  idea  of  ever  owning  anything  to  hedge. 
Suppose  that  A,  a  flour-miller,  buys  a  line  of  May  wheat  from  B,  a 
speculator,  in  order  to  cover  a  forward  contract  for  the  delivery  of 
flour;  then  gradually  sells  out  the  contracts  as  he  delivers  the  flour. 
Some  of  his  contracts  may  remain  open  for  five  or  six  months.  But  B 
has  no  intention  of  staying  “short”  for  such  a  length  of  time.  He 
buys  in  his  contract  from  C,  and  forgets  all  about  the  transaction  long 
before  A  is  ready  to  close  it  out.  C,  in  turn,  buys  tire  contract  in 
from  D,  D  from  E,  and  so  on,  the  “short  side”  of  the  contract  passing 
from  hand  to  hand  till  finally  it  is  bought  in  from  a  grain  house  which 
remains  short  till  delivery  date  and  then  fulfils  the  contract  by  delivery. 
In  the  meantime,  however,  A  may  have  decided  to  close  out  his  last 
remaining  contracts.  He  sells  to  X;  X  sells  to  Y,  and  so  the  “long 
side”  of  the  contract  passes  from  hand  to  hand  till  it  reaches  someone 
who  is  willing  to  accept  delivery,  or  possibly  is  bought  by  a  speculator 
who  has  already  sold  it  short  at  the  other  end  of  the  line,  and  so  is  can¬ 
celed  out.  Most  of  the  intermediate  holders  of  the  contract  were 
speculators,  not  hedgers,  yet  each  played  an  essential  part  in  the  hedg¬ 
ing  transaction  by  carrying  for  a  part  of  the  time  the  risk  which  had 
to  be  carried  by  someone  all  the  time.  It  is  difficult  to  see  how  the 
situation  would  be  better,  from  the  social  standpoint,  if  one  speculator 
carried  the  risk  clear  through  than  it  is  with  a  succession  of  speculators 

1  Arthur  Richmond  Marsh  estimated  some  years  ago  that  not  over  25  per  cent 
of  the  trades  made  through  the  cotton  futures  market  were  speculative.  ( Annals 
of  the  American  Academy  of  Political  and  Social  Science,  XXXVIII  [September, 
iq  1 1  ],  276.)  But  the  estimates  given  in  chap,  xi,  concerning  the  volume  of  futures 
trading,  indicate  that  even  if  it  is  figured  that  every  bushel  of  grain  is  hedged  three 
times  on  its  way  from  the  farmer  to  the  baker  the  number  of  direct  hedging  trades 
is  a  minor  fraction  of  the  total  volume  of  exchange  trading. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


377 


each  carrying  it  for  a  short  time.  Certainly  it  is  much  easier  to  find 
someone  able  and  willing  to  carry  the  load  when  facilities  are  offered 
for  getting  out  of  the  trade  at  will.1 

To  summarize  this  discussion:  the  same  possibility  of  using  a 
contract  either  for  the  purpose  of  hedging  a  legitimate  risk  or  for  the 
purpose  of  creating  a  gambling  risk  which  we  saw  in  the  Lloyds  con¬ 
tracts  arises  in  connection  with  “future  contracts”  on  the  produce 
exchanges.  When  a  grain  merchant  sells  a  future  contract  to  hedge 
against  a  fall  in  prices  while  he  is  marketing  his  purchases  of  cash  grain, 
or  a  flour-miller  buys  a  future  contract  to  protect  himself  against  loss 
while  he  is  manufacturing  flour  which  he  has  agreed  to  deliver,  he  is 
securing  protection  against  a  definite  risk  in  much  the  same  way  that 
one  secures  protection  against  an  incalculable  hazard  through  a  Lloyds 
policy,  but  in  both  cases  the  only  way  that  the  insuring  or  hedging 
individual  gets  rid  of  his  risk  is  by  transferring  it  to  someone  else  who 
assumes  it  as  a  speculation.  The  whole  machinery  of  the  produce 
exchange  finds  its  justification  in  the  facilities  which  it  affords  for 
carrying  on  certain  types  of  business  with  a  minimum  risk  and  conse¬ 
quently  at  a  minimum  cost.  There  is  no  question  that  it  is  sound 
business  policy  to  make  use  of  the  hedging  market  whenever  a  hedging 
contract  can  be  secured  on  reasonable  terms,  but  the  existence  of  a 
hedging  market  presupposes  the  existence  of  a  group  of  speculators 
who  take  the  risk  off  the  business  man’s  shoulders,  and  there  has  as 
yet  been  found  no  way  to  prevent  these  contracts  being  bought  and 
sold  in  a  purely  gambling  spirit.  A,  the  speculator,  in  relieving  B  of 
risk  certainly  performs  a  valuable  service  for  society,  but  A  does  not 
know  whether  he  is  relieving  B  of  risk  or  buying  contracts  from  C  who 
is  speculating  on  the  opposite  side  of  the  market,  and  if  the  result  is 
to  impoverish  A  or  to  bring  him  unexpected  “easy  money”  the  effect 
is  quite  as  demoralizing  as  when  similar  occurrences  take  place  through 
the  medium  of  the  race  course  or  the  roulette  wheel. 

In  any  case  it  is  clear  that  the  mixing  of  speculation  with  other 
types  of  business  is  likely  to  be  bad  for  the  other  business.  No  busi¬ 
ness  man  thinks  of  employing  his  surplus  funds  during  a  slack  season 
in  writing  insurance  policies  on  his  friends’  property,  and  the  employ¬ 
ment  of  surplus  funds  in  speculation  by  business  men  in  general  in 

1  The  reader  will  not  fail  to  notice  the  parallel  between  this  process  of  passing 
on  the  risk  of  price  changes  and  the  practice  at  Lloyd’s  by  which  underwriters 
reinsure  all  or  part  of  a  marine  risk  when  they  apprehend  that  a  loss  has  taken 
place. 


37» 


RISK  AND  RISK-BEARING 


order  to  furnish  other  business  men  with  protection  against  price 

V 

fluctuations  is  quite  as  unsound.  This  is  true,  not  so  much  because 
the  man  who  speculates  as  a  side  Kne  lacks  expert  knowledge,  but 
simply  because  it  diverts  energy  and  time  from  the  principal  business 
into  the  side  line,  and,  more  important,  creates  a  new  and  unnecessary 
hazard  affecting  the  working  capital  of  the  principal  business.  Society 
needs  speculators,  but  the  proper  source  for  speculative  funds  is  the 
accumulation  of  surplus  funds  in  the  hands  of  those  who  are  not 

actively  engaged  in  other  business  and  can  afford  to  take  a  series  of 

/ 

losses  without  flinching  in  the  expectation  of  making  it  back  in  the 
long  run.  The  great  weakness  of  present-day  speculation  is  that  there 
are  too  many  people  furnishing  speculative  contracts  who,  either  on 
account  of  the  needs  of  their  other  lines  of  business  or  on  account  of 
absolute  limitation  of  funds,  cannot  stick  through  the  long  run  and 
are  “ wiped  out”  by  the  first  or  second  unexpected  turn  of  the  market. 

So  much  emphasis  has  been  laid  upon  the  service  of  exchanges  in 
making  hedging  possible,  that  there  is  danger  of  overlooking  the  fact 
that  an  exchange  is  a  market,  and  as  a  market  has  a  function  to  per¬ 
form  in  bringing  about  such  an  adjustment  of  prices  as  will,  on  the 
one  hand,  clear  the  market  within  a  crop  year  of  substantially  the 
entire  crop,  and,  on  the  other  hand,  stimulate  an  increase  or  decrease 
of  supply  by  producers  in  harmony  with  changing  conditions  of  con¬ 
sumers’  demand.  As  was  pointed  out  in  chapter  xii,  such  adjustment 
is  effected  in  part  through  manipulation  of  the  carry  over,  but  this 
method  is  effective  only  for  absorbing  minor  fluctuations  in  demand. 
Both  the  adjustment  of  the  carry-over  and  the  slower  but  more  effec¬ 
tive  adjustment  of  production  and  consumption  are  effected  chiefly 
through  the  agency  of  price;  the  question  whether  organized  specula¬ 
tion  assists  in  such  adjustment  is  therefore  of  primary  importance. 

The  tests  of  a  satisfactory  price  level  are,  first,  does  it  adjust 
itself  quickly  and  smoothly  to  changes  in  the  demand  or  supply  situa¬ 
tion  as  such  changes  become  known,  and,  second,  is  it  relatively  free 
from  fluctuations  which  are  not  the  result  of  such  changes.  On  the 
one  hand,  it  is  desirable  that  any  change,  whether  an  increase  or  a 
decrease,  which  is  to  be  caused  by  a  given  condition,  shall  take  place  as 
soon  as  possible  after  that  condition  becomes  known.  If,  for  instance, 
a  crop  shortage  necessitates  a  decrease  in  consumption,  it  is  better 
that  such  decrease  shall  be  brought  about  as  early  in  the  preceding  crop 
year  as  possible,  in  order  that  the  carry  over  from  the  fat  into  the 


SOCIAL  ASPECTS  OF  RISK-BEARING 


379 


lean  year  may  be  large  enough  to  equalize  the  consumption.  In 
general,  the  sooner  a  change  in  price  occurs  the  less  violent  it  need  be; 
the  price-making  function  of  the  speculator  is  to  anticipate  changes 
of  price-making  conditions,  and  by  his  purchases  and  sales  expedite 
the  adjustment  of  prices  to  them.  If  his  anticipations  are  correct,  his 
purchases  will  be  made  in  advance  of  increases  in  price  which  would 
ultimately  occur  anyway,  and  his  profit  may  be  regarded  as  a  compen¬ 
sation  for  facilitating  the  adjustment;  if  his  anticipations  are  wrong 
his  losses  are  the  penalty  he  pays  for  obstructing  the  adjustment. 
The  amount  of  the  profit  or  loss  in  the  individual  case  bears  no  relation 
to  the  value  of  the  social  service  or  damage  rendered,  but  as  the  most 
of  the  profits  of  the  successful  come  out  of  the  losses  of  the  unsuccess¬ 
ful,  society,  outside  the  group  of  speculators,  has  no  direct  concern 
with  the  size  of  the  individual  profits  and  losses.1 

It  may  be  added  that  the  operations  of  a  skilled  group  of  fore¬ 
casters,  whose  purchases  and  sales  hasten  the  adjustment  of  prices 
to  their  normal  level,  tend  to  reduce  the  risks  of  trade,  for  the  reason 
that  buyers  of  grain  and  other  speculative  commodities,  even  if  they 
do  not  hedge,  carry  a  somewhat  smaller  risk  of  adverse  changes  in 
price  if  the  market  is  so  organized  that  prices  at  any  given  time  reflect 
the  consensus  of  skilled  and  informed  judgment  concerning  the  demand 
and  supply  situation.  This  point  is  of  more  importance,  however,  in 
connection  with  stock  speculation,  and  will  be  discussed  in  that  con¬ 
nection  in  a  later  paragraph. 

The  conclusions  just  set  forth,  in  regard  to  the  tendency  of  specu¬ 
lation  to  reduce  the  fluctuations  of  price  by  hastening  their  approach, 
rest  entirely  upon  theoretical  reasoning.  It  would  be  desirable,  if 
possible,  to  fortify  them  with  statistical  evidence,  but  the  facts  avail¬ 
able  are  entirely  inconclusive.  So  many  other  factors  enter  the  situa¬ 
tion  alongside  the  influence  of  speculation  that  it  is  impossible  to 
isolate  the  effects  of  this  particular  factor.3 

1  Cf.  Lavington,  “The  Social  Interest  in  Stock  Exchange  Speculation,” 
Economic  Journal,  XXIII,  36-52.  Professor  Lavington  correctly  indicates  that 
in  specific  cases  the  speculator’s  services  are  enormously  overpaid,  but  does  not  note 
that  the  rewards  of  successful  prognostications,  which  promote  the  adjustment  of 
prices  to  their  theoretically  correct  level,  are  chiefly  paid  in  the  form  of  penalties 
by  those  whose  unsuccessful  prognostications  retard  such  adjustment. 

3  The  possible  methods  of  approach  seem  to  be  four:  to  compare  prices  of  the 
same  commodity  at  the  same  time  in  different  places;  to  compare  prices  at  the 
same  market,  or  in  similar  markets,  at  different  times;  to  compare  prices  of  different 
grades  of  the  same  commodity  during  the  same  period  in  the  same  market;  and  to 


380 


RISK  AND  RISK-BEARING 


One  other  point  must  be  considered,  the  ethics  of  short  selling. 
Frequently  the  short  seller  is  condemned  for  “selling  what  he  does  not 
own”;  “causing  depreciation  in  the  value  of  other  people’s  property”; 
and  “dealing  in  fictitious  commodities.”  Analysis  of  what  the  short 
seller  does  fails  to  sustain  the  attitude  which  is  expressed  in  these 
invectives.  Inherently  it  is  no  more  evil  to  cause  a  decline  in  the  value 
of  other  people’s  property  than  it  is  to  cause  an  increase,  if  the  decline 
or  increase  is  caused  by  a  change  in  the  condition  of  the  market  and 
not  a  change  in  the  usefulness  of  the  property  itself.  The  price  of 
anything  represents  a  compromise  between  the  interests  of  the  buyer 
and  of  the  seller.  If  a  short  seller  forces  prices  unduly  low,  he  may 
injure  those  who  have  occasion  to  sell  during  the  time  of  his  influence, 
but  he  correspondingly  benefits  those  who  buy  during  the  same  period. 
Moreover,  whatever  he  sells  he  must  later  buy,  so  that  the  net  effect 
of  his  sales  and  purchases  is  neither  to  increase  or  decrease  prices;  it 
is  merely  to  increase  the  turnover,  just  as  is  the  case  with  the  specula- 

compare  prices  of  different  commodities  whose  markets  are  in  most  respects  similar 
except  that  some  have  and  some  have  not  facilities  for  speculative  trading.  None 
of  these  methods  is  satisfactory.  If  we  compare  prices  of  the  same  commodity  in 
different  parts  of  the  world,  we  meet  the  difficulty  that  the  prices  in  the  non- 
speculative  market  are  directly  influenced  by  those  in  the  speculative  market, 
and  vice  versa.  If  we  compare  the  prices  of  different  grades  of  the  same  com¬ 
modity,  we  meet  the  same  difficulty;  the  prices  of  the  grades  deliverable  on  con¬ 
tracts  and  those  not  so  deliverable  are  interdependent.  If  we  compare  the  range 
of  fluctuation  of  prices  before  the  introduction  of  future  trading  with  the  range 
since,  we  meet  the  difficulty  that  the  introduction  of  organized  speculation  has 
been  accompanied  by  other  changes,  such  as  the  introduction  of  telegraphic  com¬ 
munication,  the  establishment  of  grading  systems,  the  improvement  of  transporta¬ 
tion  and  storage,  and  the  auction  system  of  buying  and  selling,  which  collectively 
far  outweigh  in  importance  the  advent  of  the  speculator.  Comparisons  of  the 
price  fluctuations  of  similar  commodities,  such  as  wheat  and  rye,  present  the 
difficulty  that  the  prices  are  not  entirely  independent  of  one  another.  It  is  quite 
probable,  however,  that  some  light  may  be  thrown  on  the  question  by  more  care¬ 
ful  study  of  this  last  kind  of  evidence  than  has  yet  been  made.  For  a  recent 
attack  on  the  question,  cf.  Boyle,  Speculation  and  the  Chicago  Board  of  Trade, 
pp.  122-24,  219,  criticized  by  the  author  in  Journal  of  Political  Economy ,  XXIX 
(January,  1921),  82-83.  Brace,  Value  of  Organized  Speculation ,  p.  58,  and  Emery, 
Speculation  on  the  Stock  and  Produce  Exchanges  of  the  United  States,  p.  127,  conclude 
from  rather  scanty  evidence  that  speculation  has  probably  increased  the  stability 
of  prices.  Usher,  “The  Influence  of  Speculative  Marketing  on  Prices,”  American 
Economic  Review,  VI,  49-60,  concludes  that  the  problem  is  not  susceptible  of  direct 
statistical  solution.  Cf.  Chapman  and  Knoop,  “Effects  of  Anticipation  in  the 
Cotton  Market,”  Economic  Journal,  XIV,  541-54. 


RISK  AND  RISK-BEARING 


381. 

tive  buyer  who  later  sells  all  that  he  buys.  What  really  breaks  a 
market  during  a  bear  raid  is  the  selling  of  weak  and  timid  owners  who 
do  not  reappear  as  buyers. 

If  the  short  seller  can  frighten  real  owners  into  selling  out  at  the 
bottom,  he  is  enabled  to  cover  his  sales  at  a  profit;  unless  they  do  so 
he  can  never  profit  by  a  fall  in  prices  of  his  own  making.  The  prac¬ 
tices  of  buying  on  narrow  margins,  placing  stop-loss  orders,  and  trad¬ 
ing  on  market  gossip  and  surface  indications  are  responsible  for  much 
imre  weakness  of  markets  and  artificial  depression  of  values  than  is 
short  selling.1 

The  other  criticisms  of  short  selling  need  no  extended  refutation. 
“  Selling  what  one  does  not  own,”  in  order  to  profit  by  a  fall  in  price, 
is  no  more  intrinsically  immoral  than  is  buying  what  one  does  not  want 
to  own  in  order  to  profit  by  a  rise.  “  Dealing  in  fictitious  commodi¬ 
ties,”  as  has  been  shown  in  chapter  xi,  expresses  a  misconception  of 
what  actually  takes  place  in  a  futures  market.  The  popular  distrust 
of  the  short  seller  is  a  good  example  of  our  tendency  to  distrust  the 
mysterious.  Short  selling  is  as  useful  as  speculative  buying.  Both 
are  useful  just  in  so  far  as  they  express  an  intelligent  judgment  of  the 
probable  trend  of  prices. 

Speculation  in  securities. — The  case  for  organized  speculation  in 
securities  presents  quite  different  features  from  those  with  which  we 
have  just  been  dealing.  The  advantages  of  this  sort  of  speculation 
relate  not  to  the  maintenance  of  facilities  for  the  direct  shifting  of 
risk  to  specialists,  as  is  done  in  hedging  and  in  insurance,  but  to  the 
maintenance  of  a  broad  market  through  which  securities  may  readily 
be  bought  and  sold  without  the  necessity  of  bidding  them  up  in  order 
to  purchase  or  offering  them  down  in  order  to  sell.  As  was  shown  in 
chapter  vii,  such  a  broad  market  makes  possible  the  elimination  of  an 
important  kind  of  risk,  namely  the  risk  that  the  investor  will  not  be 
able  to  get  his  money  back  when  he  needs  it;  and  at  the  same  time 
makes  it  possible  for  the  corporation  which  uses  the  capital  to  remain 
free  from  the  risk  which  would  result  from  an  agreement  to  repay  it 
on  demand.  The  free  shifting  of  investments  through  a  stock  market, 
or  for  that  matter  through  an  active  “  over-the-counter  ”  market,  is 
facilitated  by  the  presence  of  a  body  of  speculators  who  stand  ready 

1  This  argument  is  much  more  significant  in  the  case  of  speculation  in  securities 
than  in  the  case  of  commodities,  as  the  investment  buyer  is  much  more  responsible 
for  the  price  level  in  the  security  market* 


382 


RISK  AND  RISK-BEARING 


to  buy  or  sell  on  slight  changes  of  price,  though  their  services  are  not 
as  essential  as  they  are  in  a  commodity  exchange. 

Speculation  in  securities,  whether  organized  or  unorganized, 
affords  an  illustration  of  specialization  in  risk-bearing  much  more 
complete  and  minute  than  that  which  is  secured  through  the  produce 
exchanges.  Each  individual  carries  securities  involving  the  amount 
and  kind  of  risk  he  prefers;  as  securities  change  in  character  they  are 
passed  on  from  one  group  to  another.  Normally,  as  a  corporation 
grows  older  its  securities  grow  less  speculative;  the  exchange  facilitates 
the  process  of  passing  them  on,  till  they  reach  the  status  of  high-grade 
investments  and  leave  the  speculative  market  to  rest  in  the  strong  box 
of  the  conservative  investor.  The  most  conservative  investments 
have  usually  passed  through  a  speculative  stage,  and  there  are  only 
two  ways  in  which  they  can  be  carried  through  this  period — either  by 
speculators  and  speculative  investors,  or  else  in  the  hands  of  a  com¬ 
paratively  small  group  of  persons  close  to  the  management  who  have 
more  faith  in  the  enterprise  than  the  general  public  has  any  cause  to 
display. 

Short  selling  is  not  as  essential  to  the  work  of  a  stock  exchange 
as  it  is  to  a  commodity  exchange,  but  its  effect  is,  on  the  whole,  to 
facilitate  the  adjustment  of  market  price  to  the  known  elements  of 
value.  As  was  noted  in  connection  with  a  similar  feature  of  the 
commodity  markets,  such  an  adjustment  decreases  the  risk  of  the 
investor.  Most  buyers  of  securities  are  not  able  to  inform  themselves 
thoroughly  in  regard  to  the  stability  of  the  corporations  whose  securi¬ 
ties  they  buy,  and  must,  to  a  large  extent,  rely  on  the  price  itself  as  a 
guide  in  determining  their  selections.  Many  buyers  establish  a 
definite  policy  of  buying  no  securities  whose  yields  do  not  fall  between 
certain  fixed  limits.  They  make  their  selections  in  large  part  on  the 
basis  of  the  risk  indicated  by  the  yield,  assuming  that  if  the  yield  is 
very  high  or  very  low  there  must  be  some  good  reason  for  it. 

This  is  far  from  being  an  ideal  method,  but  it  is  probably  one  of 
the  best  which  is  available  to  the  average  investor,  provided  the  yields 
are  determined  in  a  genuine  competitive  market.  Unless  such  a 
market  exists,  however,  the  method  breaks  down  completely.  Short 
selling  makes  it  much  more  difficult  for  anyone  to  maintain  an  artifi¬ 
cially  high  price  for  a  security,  and  then  sell  it  to  investors  on  the 
strength  of  the  apparently  favorable  market  rating  evidenced  by  the 
price  itself. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


383 


The  value  of  this  protective  feature  of  the  security  markets 
would  be  much  greater  if  some  method  were  devised  by  which  short 
sales  could  be  made  safely  in  a  larger  number  of  securities.  As  the 
case  stands  now,  a  speculator  may  be  quite  right  in  his  judgment 
that  a  certain  security  is  selling  at  too  high  a  price,  and  must  sooner 
or  later  decline,  yet  it  may  be  unsafe  for  him  to  sell  it  short  because 
of  the  risk  that  the  floating  supply  will  be  bought  up  by  someone 
who  will  then  refuse  to  make  loans  of  stock  for  the  use  of  short  sellers.1 

The  cases  where  the  services  of  the  short  seller  would  be  most 
useful  are  those  where  securities  are  being  distributed  by  under¬ 
writers  at  what  the  informed  know  to  be  unduly  high  prices,  yet  the 
most  of  the  certificates  are  still  in  the  hands  of  the  underwriters,  so 
that  it  is  impossible  for  short  sellers  to  break  the  market  down  to  its 
proper  level.  The  uninformed  are  permitted  to  buy  the  security 
on  the  strength  of  the  high  quotations  established  by  manipulation. 
Short  selling  is  practically  confined  to  a  few  active  securities. 

In  the  light  of  the  considerations  set  forth  above,  we  may  agree 
with  the  judgment  of  a  leading  economist  that  speculation  has  both 
benefits  and  evils,  but  the  benefits  accrue  chiefly  to  the  general  public, 
while  the  evils  accrue  to  the  speculators  themselves.  One  adverse 
feature  of  the  situation,  however,  remains  to  be  considered. 

We  have  emphasized  above,  and  economists  generally  have 
emphasized,  the  service  of  a  body  of  expert  speculators  in  studying 
the  indications  of  coming  change,  and  expressing  their  judgments  in 
purchases  and  sales  which  tend  to  bring  the  level  of  prices  as  soon  as 
possible  into  line  with  all  the  known  facts.  Economists  have  not, 
however,  generally  recognized  the  opposite  tendency  involved  in  the 
fact  that  speculation,  especially  organized  speculation,  gives  these 
same  students  a  financial  incentive  to  conceal  the  facts  of  which  they 
become  cognizant. 

Suppose  a  certain  speculator  obtains  advance  information  of 
facts,  which  when  made  public  will  inevitably  raise  the  price  of  certain 
commodities  or  securities.  He  cannot  take  advantage  of  his  knowl- 

1  As  this  is  being  written,  the  Piggly  Wiggly  case  furnishes  an  excellent  illustra¬ 
tion.  Stock  which  could  be  bought  for  December  delivery  at  $55  was  selling  in 
March,  1923,  around  $75,  obviously  an  artifically  high  price.  Yet  short  sellers 
who  attempted  to  take  advantage  of  this  situation  suffered  severely  because  they 
found  themselves  unable  to  get  a  sufficient  supply  of  loanable  certificates  to  keep 
themselves  ‘‘short”  until  the  partial  payment  stock  could  be  secured. 


3^4 


RISK  AND  RISK-BEARING 


edge  except  by  purchases,  and  purchases  tend  to  cause  the  rise  to 
occur  at  once,  which  is  socially  desirable.  But  if  he  can  induce 
others  to  sell  freely  until  he  has  completed  his  purchases  he  can  make 
them  more  advantageously;  thus  he  has  a  financial  incentive  to  keep 
his  news  secret,  and  to  do  what  he  can  to  stimulate  a  belief  that  prices 
are  actually  going  down.  This  direct  incentive  to  speculators  to 
become  spreaders  of  darkness  instead  of  light  goes  very  far  to  offset 
the  social  advantage  of  having  prices  influenced  by  the  judgment  of 
special  students  of  the  market  outlook. 

Finally,  there  can  be  no  doubt  that  from  the  social  standpoint 
much  of  the  energy  which  is  spent  by  speculators  in  study  of  the 
behavior  of  organized  markets,  and  much  of  the  time  of  brokers  and 
their  employees,  represents  sheer  waste.  The  function  of  scrutinizing 
the  news  for  indications  of  coming  change  in  the  security  markets  is 
valuable,  but  it  is  greatly  overdone,  and  too  largely  intrusted  to  those 
who  have  no  qualifications  for  doing  it  well. 

Land  speculation. — The  case  of  land  speculation  is  worthy  of 
special  attention  because  there  is  a  very  widespread  belief  that  the 
land  speculator  is  especially  deserving  of  condemnation  as  a  parasite. 
There  seems  to  be  no  basis  for  the  assumption  that  the  land  specula¬ 
tor’s  social  significance  is  particularly  different  from  that  of  any  other 
speculator,  or  that  he  can  make  a  profit  out  of  price  changes  except 
by  promoting  those  uses  of  land  which  are  socially  most  desirable. 

In  the  case  of  land  which  can  be  rented  and  fully  utilized  during 
the  time  it  is  being  held  by  a  speculator,  as  is  generally  the  case  with 
farm  land,  there  is  no  waste  of  social  resources;  the  rental  value  of  the 
land  is  no  greater  and  no  less  than  it  would  be  if  the  land  were  held  by 
a  permanent  investor.  The  social  problems  involved  are  those 
generally  associated  with  tenancy. 

In  the  case  of  land  which  cannot  be  put  to  productive  use  till  it 
is  improved  and  is  being  held  unimproved  by  a  speculator,  there  is 
apparently  a  waste  of  resources,  and  it  is  in  connection  with  this  type 
of  land  speculation  that  the  system  of  free  buying  and  selling  has  been 
most  condemned.  Yet  no  speculator  has  any  incentive  to  hold  land 
out  of  service  any  longer  than  is  necessary  in  order  to  reserve  it  for 
its  most  productive  use.  If  a  speculator  believes  that  ten  years  from 
now  his  lots  will  be  worth  enough  to  justify  putting  a  $100,000  building 
on  them,  he  cannot  afford  to  put  a  $10,000  building  on  them  now, 
unless  the  smaller  building  will  pay  for  itself  in  ten  years  so  that  it 
can  be  scrapped  without  loss  to  make  way  for  the  more  productive 


SOCIAL  ASPECTS  OF  RISK-BEARING  385 

use.  In  such  a  case  it  is  socially  desirable  to  hold  the  land  out 
of  use. 

In  general,  if  the  speculator  is  right  in  his  judgment  that  his  land 
will  be  worth  enough  more  some  years  hence  to  pay  interest  on  what 
he  could  get  for  it  now,  plus  a  profit,  society  gains  by  having  the  land 
held  out  of  use  till  that  time.  If,  on  the  other  hand,  the  most  profitable 
way  to  use  the  land,  in  the  long  run,  is  to  improve  it  at  once,  and  then 
scrap  the  improvements  later  to  make  way  for  better  ones,  it  is  to  the 
speculator’s  interest  to  do  so  or  to  sell  to  someone  who  will.  Here, 
as  in  other  types  of  speculation,  the  line  of  greatest  profit  coincides 
with  the  line  of  social  interest.  Speculators  may,  and  often  do,  retard 
the  use  of  land  for  purposes  for  which  it  is  desirable  that  it  be  used, 
but  they  lose  money  by  so  doing. 

Of  course,  what  has  been  said  above  concerning  the  possibility 
of  profiting  by  dissuading  others  from  following  the  line  of  their 
best  interests,  withholding  from  them  valuable  information,  and 
disseminating  errors,  applies  here,  but  it  is  probably  of  less  importance 
than  it  is  in  the  case  of  the  organized  markets. 

V.  RISK-BEARING  AND  THE  SOCIAL  ORDER 

In  any  evaluation  of  our  social  machinery  for  dealing  with 
uncertainty,  the  largest  question  involved  is  the  rating  which  is  to 
be  given  the  present  economic  order  as  a  whole,  from  the  standpoint 
of  its  tendency  to  reduce  or  increase  the  element  of  risk.  One  of  the 
chief  objects  at  which  men  are  aiming  in  their  economic  efforts  is  the 
attainment  of  security.  Does  the  economic  system  they  have 
established  promote  this  purpose  reasonably  well  ? 

The  question  is  not  answerable,  even  in  theory,  unless  it  is  so 
restated  as  to  involve  a  direct  comparison  between  the  economic 
order  under  consideration  and  some  other  order,  either  historical  or 
hypothetical.  Viewing  the  economic  system  of  free  enterprise  merely 
as  an  isolated  phenomenon,  without  consideration  of  any  possible 
alternative  system,  the  observer  is  equally  justified  in  rendering  a 
verdict  highly  favorable  or  highly  unfavorable.  One  man  is  filled 
with  amazement  and  admiration  that  the  system  works  as  well  as  it 
does;  another  is  aghast  that  it  does  not  work  better;  there  need  be 
no  difference  of  opinion  between  them  as  to  the  actual  facts  of  the 
case  at  all.  Their  difference  of  attitudes  is  merely  aesthetic.  As  soon, 
however,  as  a  comparison  is  attempted  between  the  present  order  and 
some  other  order,  we  have  some  chance  of  reaching  a  rational  judgment. 


386 


RISK  AND  RISK-BEARING 


Practically  speaking,  there  are  only  two  bases  on  which  a  judgment 
of  any  interest  concerning  the  efficiency  of  the  modern  capitalistic 
organization  can  be  formulated:  namely,  a  comparison  with  the 
medieval  small-scale  non-competitive  and  non-speculative  economy; 
and  secondly,  a  comparison  with  the  socialized  large-scale  non¬ 
competitive,  non-speculative  economy  which,  in  some  form,  is  preferred 
by  most  radical  critics  of  our  present-day  organization. 

As  compared  with  the  situation  which  prevailed  before  the 
introduction  of  the  machine  technique,  corporate  organization, 
extensive  commerce,  and  complex  finance,  the  case  is  far  from  clear. 
In  relation  to  the  hazards  which  arise  from  man’s  ignorance  of  the 
workings  of  nature,  the  average  man  is  more  secure  than  were  his 
ancestors.  Public  and  private  facilities  for  the  maintenance  of  health 
are  far  better  than  ever  before  in  the  history  of  the  world;  weather 
forecasting  has  greatly  reduced  the  hazards  of  storm  and  flood; 
dangerous  animals  have  been  driven  far  from  the  homes  of  most  men ; 
better  food,  better  clothing,  and  better  shelter  make  man  independent, 
as  never  before,  of  the  powers  of  physical  nature.  The  hazards  of 
war  also,  in  spite  of  the  formidable  evidence  to  the  contrary,  are 
probably  less  than  was  the  case  when  our  scientific  knowledge  and 
economic  interdependence  was  less.  War  grows  more  spectacular, 
but  less  frequent,  and  though  the  weapons  of  war  grow  more  deadly, 
the  diseases  of  the  camps  kill  fewer  and  fewer. 

Let  us  consider  next  the  risks  of  maladjustment  of  production 
and  marketing.  It  is  obvious  that  modern  methods  of  production 
involve  a  great  deal  more  uncertainty  with  regard  to  the  exact  coin¬ 
cidence  of  desire  and  supply  than  did  the  simpler  type  of  organization. 
When  the  medieval  gildsman  made  a  pair  of  shoes  for  his  neighbor,  he 
knew  before  beginning  work  that  a  market  existed  for  the  shoes. 
And  even  earlier  when  he  was  acquiring  his  skill  or  establishing  his 
shop,  he  knew  pretty  accurately  the  course  of  demand  for  his  product 
during  the  period  when  the  acquired  skill  and  capital  were  to  be  used. 

When  goods  are  made  by  the  modern  factory  process,  on  the  other 
hand,  there  is  no  exact  knowledge  of  the  coincidence  of  the  productive 
effort  and  the  desire  for  its  fruits.  When  the  clothing  manufacturer 
starts  the  process  of  making  a  suit  of  clothes,  he  does  so  in  the  faith 
that  somewhere  in  the  world  is  a  man  of  the  size  and  shape  to  fit  that 
suit,  and  that  the  paths  of  the  suit  and  the  man  will  cross  at  the 
exact  moment  when  the  man  desires  to  purchase  a  new  suit  of  clothes. 
Viewed  from  the  standpoint  of  the  single  transar-tion,  such  an  effort 
'ooks  hazardous  in  the  extreme. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


3^7 


The  degree  of  hazard  is  not  to  be  estimated,  however,  on  the  basis 
of  the  probability  of  the  single  transaction’s  turning  out  well,  but  on 
the  basis  of  the  average  result  as  estimated  in  accordance  with  the 
law  of  large  numbers.  And  from  this  standpoint  the  broader  the 
market,  the  less  the  risk.  If  of  5,000  suits  that  were  sold  last  year, 
9  per  cent  were  of  a  certain  size  and  17  per  cent  of  another  size,  there 
is  slight  probability  that  the  proportion  of  men  of  these  sizes  in  the 
next  group  of  5,000  buyers  will  differ  widely  from  the  preceding 
result.  As  the  number  of  cases  grows  larger,  the  percentage  of  error 
grows  smaller.  The  individual  varies,  the  crowd  remains  the  same. 
It  is  only  the  exceptional  individual,  who  in  size  or  shape  fails  to 
conform  to  the  mass,  whose  wants  cannot  be  supplied  by  the  method 
of  mass  production. 

Most  problems  of  risk  reduce  themselves  finally  to  these  two 
types:  Does  the  increase  in  the  value  of  a  commodity,  which  will 
result  from  its  being  transported  to  another  point  in  space,  promise 
to  offset  the  costs  and  risks  of  the  undertaking?  Does  the  increase 
in  value  anticipated  from  transferring  a  commodity  by  storage  to  a 
remote  time  promise  to  offset  the  costs  and  risks  involved  in  the 
undertaking  ?  In  the  case  of  transportation,  the  direct  and  calculable 
cost  is  the  more  serious  factor;  in  the  case  of  storage  the  risk  element 
is  more  likely  to  control,  but  in  both  cases  the  principle  is  the  same; 
the  anticipated  increase  in  value  must  equal  the  actual  known  costs 
of  the  operation,  plus  the  probable  cost  or  loss  multiplied  by  the  frac¬ 
tion  which  represents  its  probability.  What  communication  is  to  the 
difficulties  of  space,  forecasting  is  to  the  difficulties  of  time;  what 
transportation  is  to  the  difficulties  of  space,  storage  is  to  the  difficulties 
of  time. 

One  of  the  first  effects  of  the  expansion  of  business  into  its  modern 
form  was  a  great  increase  in  the  space  area  involved  within  the  cal¬ 
culations  of  the  single  unit.  In  the  beginning  this  expansion  of  space 
involved  an  increase  of  risk.  When  wool  was  raised  in  northern 
England  to  be  woven  into  cloth  in  Belgium,  and  worn  as  clothing  in 
London,  Paris,  Spain,  and  Denmark,  it  was  impossible  for  an  indi¬ 
vidual  who  was  responsible  for  the  early  stages  of  the  productive 
process  to  know  the  conditions  at  the  point  where  the  later  stages 
would  be  carried  through,  and  the  result  was  the  injection  of  a  large 
element  of  risk  into  men’s  calculations. 

The  later  course  of  capitalistic  development,  on  the  other  hand, 
has  been  in  the  direction  of  eliminating  space  risk.  Rapid  transporta- 


388 


RISK  AND  RISK-BEARING 


tion  and  improved  communication  through  postal,  telegraph,  tele¬ 
phone,  and  radio  service  have  made  a  continent,  so  far  as  effect  of 
space  upon  risk  is  concerned,  smaller  than  an  old-time  county.  The 
trader  buying  wheat  in  New  York  for  export  has  Liverpool  quotations 
no  more  than  ten  minutes  old,  and  even  in  markets  for  less  stand¬ 
ardized  commodities  and  in  dealings  with  remote  parts  of  the  world, 
the  factor  of  ignorance  due  to  distance  has  been  reduced  to  a  fraction 
of  its  former  importance. 

On  the  other  hand,  the  risk  from  the  other  type  of  extension  of 
the  market  has  tended  to  grow  more  and  more  important.  The 
modern  productive  processes  not  only  involve  a  wider  range  of  ter¬ 
ritory  but  a  greater  scope  of  time.  Between  the  opening  of  an  iron 
mine  in  Minnesota  and  the  purchase  of  the  resulting  needle  by  a 
housewife  in  Texas,  much  time  must  elapse,  and  the  effect  of  time  is 
to  multiply  the  possibilities  of  miscalculation.  And  our  technique 
of  reaching  into  the  future  to  secure  a  basis  for  our  calculations  is 
vastly  inferior  to  our  technique  of  reaching  across  space,  with  the 
added  complication  that,  whereas  goods  shipped  in  error  from  one 
point  to  another  can  generally  be  shipped  back,  goods  carried  through 
in  error  from  one  point  of  time  to  another  can  never  be  returned. 

To  these  considerations  two  others  must  be  added.  The  risk  of 
loss  in  a  given  undertaking  depends  not  only  upon  the  amount  of 
hazard  to  which  the  capital  or  acquired  skill  invested  in  it  will  be 
exposed  before  the  normal  completion  of  the  undertaking;  it  depends 
also  upon  the  completeness  and  rapidity  with  which  the  investment 
can  be  rescued  in  case  the  adverse  conditions  appear.  This  is  chiefly 
a  question  of  the  degree  of  specialization.  The  capital  invested  in  an 
office  building  or  a  building  suitable  for  light  manufacture  can  be 
utilized  without  tremendous  loss  if  the  enterprise  in  connection  with 
which  it  was  originally  invested  proves  a  failure,  whereas  the  capital 
invested  in  a  steel  plant,  a  stock  of  pogo  sticks,  or  an  equipment  for 
manufacturing  five-inch  shells  can  be  utilized  for  few  other  purposes  in 
case  the  calculations  of  the  investor  prove  false.  It  is  at  this  point 
that  the  indictment  of  insecurity  against  the  modern  organization 
has  most  force,  with  reference  both  to  the  investment  of  capital  and 
the  investment  of  time  in  fitting  one’s  self  for  a  particular  type  of 
labor.  The  unskilled  laborer  is  dependent  for  his  support  not  on  the 
continuance  of  the  particular  industry  in  which  he  is  employed,  but 
on  the  continuance  of  activity  of  business  in  general.  But  the  pastry 
cook  must  lose  his  investment  of  time  in  acquiring  skill  in  manu- 


SOCIAL  ASPECTS  OF  RISK-BEARING  389 

facturing  a  given  type  of  dessert  as  soon  as  public  taste  turns  to  a 
rival  delicacy. 

Finally  competition  may  bring  loss  to  the  individual  even  when 
it  brings  gain  to  the  group.  All  competitive  business  involves  in¬ 
eradicable  elements  of  risk.  We  improve  the  merchant’s  technique 
of  studying  the  market,  and  we  increase  correspondingly  the  number 
of  things  he  must  know.  We  may  develop  a  technique  of  forecasting 
price  changes,  but  if  we  share  the  technique  with  those  to  whom  we  sell 
and  those  from  whom  we  buy,  the  difficulty  of  squeezing  a  living  out 
of  price  fluctuations  remains  unchanged.  If  we  establish  a  hedging 
system  to  relieve  the  merchant  of  the  risks  of  price  changes,  presently 
competition  narrows  his  margin  of  profit  so  that  his  certainty  of  an  ade¬ 
quate  return  for  his  efforts  is  again  removed.  If  we  make  the  trader’s 
lot  more  secure  by  creating  insurance  companies,  police  forces,  and 
other  agencies  for  relieving  him  of  risk,  we  attract  more  traders  into 
competition  with  him.  Efforts  to  make  competitive  business  safe 
for  all  who  engage  in  it  are  like  efforts  so  to  improve  the  standards  of 
athletic  coaching  in  a  community  that  no  one  will  lose  any  more 
contests. 

It  is  a  striking  fact,  however,  that  the  number  of  persons  subject 
to  the  risks  of  the  market  and  of  competition  has  vastly  expanded. 
We  release  the  farmer  from  the  grip  of  manorial  custom,  and  leave 
him  free  to  experiment  with  new  methods  which  may  greatly  increase 
his  income,  but  which  may  ruin  him.  We  free  the  peasant  from  the 
soil  and  send  him  out  to  seek  his  fortune;  he  may  rise  much  higher 
than  his  ancestors  ever  dreamed  of  rising,  but  he  may  also  much 
more  easily  sink  to  pauperism.  In  granting  opportunity,  we  have 
imposed  risk.  The  average  standard  of  living  of  the  agricultural 
laborer  has  advanced  greatly,  but  the  variation  in  status  has  increased 
still  more. 

In  other  departments  of  life  the  same  thing  is  true.  The  guilds- 
man,  the  monk,  and  the  soldier  of  the  precapitalistic  era  all  found 
their  place  in  life  as  members  of  organizations;  they  rose  or  fell  chiefly 
as  those  organizations  rose  or  fell.  Modern  individualism  has  cut 
the  bonds  between  individuals,  and  given  them  the  possibility  of 
choice ,  and  with  free  choice  goes  increased  risk. 

The  question  of  the  relative  value  of  medieval  and  modern  organi¬ 
zations,  from  the  standpoint  of  the  risk  involved,  is  therefore  an  open 
one.  The  range  of  uncertainty  has  for  most  men  increased,  but  the 
uncertainty  arises  largely  from  the  possibility  of  better  things;  whether 


390 


RISK  AND  RISK-BEARING 


these  possibilities  are  worth  the  risks  they  entail  is  largely  a  matter 
of  the  individual’s  preference  as  to  the  kind  of  world  he  wants  to 
live  in. 

The  question  of  the  incidence  of  risk  in  a  socialist  state,  as  com¬ 
pared  with  that  in  a  capitalist  state,  is  too  large  for  complete  analysis 
here,  because  of  the  extent  to  which  a  final  conclusion  in  regard  to  it 
depends  on  estimates  of  such  unknown  variables  as  the  effect  of  the 
abolition  of  independent  business  opportunities  on  the  caliber  of  men 
offering  themselves  for  public  office,  and  the  effect  of  the  socialization 
of  productive  property  on  the  individual’s  feeling  of  responsibility 
to  do  faithful  work.  All  that  we  shall  attempt  is  a  consideration  of 
the  direct  effect  of  the  change  to  a  socialist  organization  on  the  amount 
of  uncertainty  involved  in  the  productive  and  distributive  processes. 

Clearly,  a  well-organized  socialist  state  could  remove  much  of  the 
uncertainty  in  man’s  life.  It  could,  as  a  military  organization  does, 
place  men  in  definite  positions  from  which  there  would  be  little  chance 
of  their  escaping  either  for  better  or  for  worse.  The  risks  of  production 
and  of  the  commodity  market  would  be  borne  by  the  group  as  a  whole, 
and  in  large  part  eliminated  by  combination;  the  risks  connected 
with  the  market  for  one’s  individual  skill  and  energy  could,  if  the 
controlling  minds  desired,  be  eliminated  by  cutting  the  connection 
between  the  demand  for  one’s  service  and  the  rate  of  one’s  wage. 

On  the  other  hand,  such  an  organization  might  as  readily  operate 
on  the  basis  of  an  unequal  distribution  of  the  community  income  to 
laborers  of  various  kinds,  with  free  competition  between  individuals 
for  the  higher  paid  and  more  difficult  positions.  If  this  latter  method 
were  followed,  the  uncertainty  of  the  individual’s  economic  future 
might  be  little  less  than  it  is  at  present. 

Or,  quite  possibly,  a  compromise  might  be  effected  whereby  the 
amount  of  individual  liberty  and  consequent  individual  risk  would  be 
less  than  it  is  at  present,  yet  greater  than  it  would  be  if  all  tasks 
were  apportioned  solely  by  political  methods,  and  income  was  divided 
equally  or  by  some  method  not  directly  connected  with  the  scarcity  of 
the  kind  of  service  which  the  individual  could  perform.  Our  own 
federal  civil  service  offers,  in  those  who  have  remained  in  it  past 
middle  life,  an  excellent  illustration  of  the  possibility  of  an  economic 
career  which  is  touched  with  the  minimum  amount  of  uncertainty 
concerning  tenure,  compensation,  and  conditions  of  work;  opportuni¬ 
ties  for  such  riskless  endeavor  the  socialist  state  might  easily  multiply. 


SOCIAL  ASPECTS  OF  RISK-BEARING 


391 


Outside  the  market  for  individual  services,  the  chief  difference 
between  the  risks  of  present-day  industry  and  those  which  we  would 
anticipate  under  a  socialistic  organization  would  arise  from  the  elimina¬ 
tion  of  the  risks  which  arise  from  the  tendency  under  competition  for 
individuals  alternately  to  accumulate  and  reduce  stocks  in  anticipation 
of  price  changes.  This  tendency,  which,  as  was  shown  in  chapter  v, 
is  the  major  cause  of  the  cyclical  tendency  of  business,  seems  to  be 
inescapable  so  long  as  individuals  make  their  business  decisions  each 
in  ignorance  of  what  the  others  are  deciding  on  the  basis  of  the  same 
evidence.  Any  system  of  centralized  control  of  production,  whether 
arising  from  governmental  monopoly  or  from  private  monopoly,  could 
in  large  part  escape  this  weakness  of  the  competitive  system,  and  save 
a  considerable  portion  of  the  waste  which  attends  the  alternation  of 
excessive  activity  and  stagnation  in  the  industrial  process.1 

1  In  view  of  the  extent  to  which  current  theory  ascribes  the  cyclical  tendency 
in  business  to  the  “pecuniary”  organization  of  society,  it  may  be  well  to  examine 
the  probable  effects  of  socialization  more  carefully.  By  the  term  “pecuniary 
organization”  there  is  designated,  rather  inaccurately,  the  system  of  directing 
production  in  such  a  way  as  to  produce  the  maximum  profit  for  business  men; 
in  other  words,  the  attempt  to  produce  those  things  for  which  the  social  demand, 
as  expressed  in  offers  of  payment,  is  the  greatest,  relative  to  the  costs  incurred. 
A  socialistic  organization  would  face  the  necessity  of  making  a  similar  adjustment 
of  supply  to  demand,  but  not  necessarily  to  demand  as  expressed  in  offers  of  purchas¬ 
ing  power  (though  if  purchasing  power  were  equalized  the  chief  objection  to  the 
method  would  disappear). 

Whether  production  be  adjusted  to  demand  as  expressed  by  offer  of  purchasing 
power,  or  by  the  ballot,  or  by  the  results  of  statistical  investigations  by  experts, 
or  by  any  other  method,  the  critical  point  in  determining  whether  the  cyclical 
tendency  would  be  eliminated,  seems  to  be  the  question  of  centralization  of  control. 
A  private  monopoly  controlled  by  the  pecuniary  calculus  would  be  freed  from  the 
tendency,  if  its  business  were  not  interdependent  with  that  of  mother  businesses 
which  are  subject  to  the  tendency;  on  the  other  hand,  in  fields  where  adjustment 
requires  time  a  group  of  independent  producers  all  controlled  by  a  philanthropic 
desire  to  direct  production  into  the  channels  of  greatest  social  efficiency  would  be 
subject  to  the  cyclical  tendency  if  they  made  their  decisions  independently  and  on 
the  basis  of  their  knowledge  of  the  same  general  situation. 


QUESTIONS 

1.  The  ultimate  effect  of  improvements  in  business  methods  is  usually  to 
lower  prices  to  consumers,  yet  society  depends  on  the  self-interest  of 
business  men,  through  profits,  to  secure  the  adoption  of  improvements. 
Is  this  rational? 

2.  Profit  is  sometimes  stated  to  be  a  compensation  for  the  “irksomeness”  of 
riskbearing.  Discuss. 


392 


RISK  AND  RISK-BEARING 


3.  Can  you  cite  cases  where  profit  is  collected  without  either  monopoly 
conditions  or  significant  risk,  (a)  temporarily?  ( b )  permanently? 

4.  Formulate  a  general  statement  of  the  conditions  under  which  profit  is 
socially  useful. 

5.  It  is  frequently  assumed  that  the  placing  of  control  in  the  hands  of  those 
who  carry  risk  tends  to  prevent  recklessness  in  the  conduct  of  business. 
Does  the  history  of  governmental  business  enterprises  confirm  this  ? 

6.  Under  a  socialistic  organization,  who  would  take  the  risks  incident  to  the 
introduction  of  new  methods? 


APPENDIX 

REFERENCES  FOR  FURTHER  READING 

CHAPTERS  I  TO  IV,  INCLUSIVE 

Fisher,  Irving.  Nature  of  Capital  and  Income ,  chap,  xvi;  Appendix  I. 
New  York:  Macmillan  Co.,  1906. 

Haynes,  John.  “Risk  as  an  Economic  Factor,”  Quarterly  Journal  of  Eco¬ 
nomics,  IX  (1895),  409-49. 

Knight,  F  H.  Risk,  Uncertainly,  and  Profit.  Hart  Schaffner  &  Marx 
Prize  Essays.  Boston:  Houghton  Mifllin  Co.  (Riverside  Press), 
1921. 

Ross,  E.  A.  “Uncertainty  as  a  Factor  in  Production,”  Annals  of  the 
American  Academy  of  Political  and  Social  Science ,  VIII  fi8q6),  304-31. 

Willett,  A.  H.  “Economic  Theory  of  Risk  and  Insurance,”  Columbia  Uni¬ 
versity  Studies  in  History ,  Economics  and  Public  Law,  Vol.  XIV.  New 
York:  Columbia  University,  1902. 

chapter  v 

Clark,  J.  M.  “Business  Acceleration  and  the  Law  of  Demand,”  Journal 
of  Political  Economy,  XXV  (March,  1917),  217-35. 

Hansen,  A.  H.  “Cycles  of  Prosperity  and  Depression  in  the  United  States, 
Great  Britain  and  Germany,”  University  of  Wisconsin  Studies  in  tht 
Social  Sciences  and  History,  No.  5.  Madison:  University  of  Wisconsin 
1921. 

Lavington,  F.  The  Trade  Cycle.  London:  P.  S.  King  Si  Son,  1922. 

Mitchell,  W.  C.  Business  Cycles.  Berkeley:  University  of  California 
Press,  1913. 

Selden,  G.  C.  “Trade  Cycles  and  the  Effort  to  Anticipate,”  Quarterly 
Journal  of  Economics,  XVI  (1902),  293-310. 

CHAPTER  VI 

Babson,  Roger  W.  Business  Barometers,  15th  ed.  Wellesley  Hills:  Babson 
Statistical  Organization,  1921. 

Gaines,  M.  W.  The  Art  of  Investment,  chap.  vii.  New  York:  Ronald 
Press,  1922. 

Hansen.  University  of  Wisconsin  Studies,  No.  5. 

Jones,  E.  D.  Investment,  chaps,  xv-xvii,  inclusive.  New  York:  Alexander 
Hamilton  Institute,  1917. 

Jordan,  D.  F.  Business  Forecasting.  New  York:  Prentice-Hall,  1921. 

Mitchell.  Business  Cycles. 

Review  of  Economic  Statistics,  passim. 


393 


394 


RISK  AND  RISK-BEARING 


Vance,  Ray.  Business  and  Investment  Forecasting.  New  York:  Brookmire 
Economic  Service,  1922. 

CHAPTER  VII 

Chamberlain,  Lawrence.  Principles  of  Bond  Investment,  chap.  ii.  New  York : 
Henry  Holt  &  Co.,  1911. 

Lavington,  F.  The  English  Capital  Market ,  chaps,  xiii-xv,  inclusive. 
London:  Methuen  &  Co.,  1921. 

CHAPTER  VHl 

I 

Atwood,  A.  W.  The  Exchanges  and  Speculation.  New  York:  Alexander 
Hamilton  Institute,  1919. 

Emery,  H.  C.  “Speculation  on  the  Stock  and  Produce  Exchanges  of  the 
United  States,”  Studies  in  History,  Economics  and  Public  Law ,  Vol. 
VII.  New  York:  Columbia  University,  1896. 

Huebner,  S.  S.  The  Stock  Market.  New  York:  D.  Appleton  &  Co.,  1922 
Meeker,  J.  E.  The  Work  of  the  Stock  Exchange.  New  York:  Ronald 
Press,  1922. 

Pratt,  S.  S.  The  Work  of  Wall  Street ,  rev.  ed.  New  York:  D.  Appleton 
&  Co.,  1921. 

II 

Chamberlain,  Lawrence.  Principles  of  Bond  Investment ,  chap.  xl. 

Dewing,  A.  S.  The  Financial  Policy  of  Corporations,  Vol.  II,  chaps,  vii-ix, 
inclusive.  New  York:  Ronald  Press,  1920. 

Moulton,  H.  G.  The  Financial  Organization  of  Society.  Chicago:  Uni¬ 
versity  of  Chicago  Press,  1921. 

CHAPTER  IX 

Browne,  Scribner.  Practical  Points  on  Stock  Trading.  New  York: 

The  Magazine  of  Wall  Street,  igi8. 

Gaines,  M.  W.  The  Art  of  Investment,  chap.  x. 

Gibson,  Thomas.  The  Pitfalls  of  Speculation.  New  York:  Moody  Maga¬ 
zine  &  Book  Co.,  1916. 

- .  “The  Facts  about  Speculation,”  serially  in  Financial  World,  1923 

Selden,  G.  C.  Investing  for  Profit.  New  York:  The  Magazine  of  Wall 
Street,  1913. 

chapter  x 

Chamberlain,  Lawrence.  Principles  of  Bond  Investment. 

Clay,  Paul.  Sound  Investing.  New  York:  Moody's  Magazine  &  Book 
Co.,  1915. 

Gaines,  M.  W.  The  Art  of  Investment. 

Jones,  E.  D.  Investment. 

Jordan,  D.  F.  Investments,  rev.  ed.  New  York:  Prentice-Hall,  1921. 
Lagerquist,  W.  E.  Investment  Analysis.  New  York:  Macmillan  Co.,  1922. 


APPENDIX 


395 


CHAPTERS  XI,  XII 

“American  Produce  Exchange  Markets,”  Annals  of  the  American  Academy 
of  Political  and  Social  Science ,  Vol.  XXXVIII  (September,  1911). 
Clark,  F.  E.  Principles  of  Marketing ,  chap.  xvii.  New  York:  Macmillan 
Co.,  1922. 

v 

Emery,  H.  C.  Studies  in  History,  Economics  and  Public  Law,  Vol.  VII. 
Hibbard,  B.  H. '  The  Marketing  of  Agricultural  Products,  chaps,  x-xiii, 
inclusive.  New  York:  D.  Appleton  &  Co.,  1921. 

Weld,  L.  D.  H.  The  Marketing  of  Farm  Products,  chaps,  xv,  xvi.  New  York: 
Macmillan  Co.,  1916. 

CHAPTERS  xill-xvn,  INCLUSIVE 

Annals  of  the  American  Academy  of  Political  and  Social  Science ,  Vol.  LXX 
(entire)  (March,  1917,  Part  I  “Life  Insurance”;  Part  II,  “Fire  Insur¬ 
ance”;  Part  III,  “Accident  and  Compensation  Irsurance.” 

Blanchard,  R.  H.  Liability  and  Compensation  Insurance.  New  York: 
D.  Appleton  &  Co.,  1917. 

Fackler,  E.  B.  Notes  on  Life  Insurance.  New  York:  Spectator  Co., 
1907. 

Gephart,  W.  F.  Principles  of  Insurance,  Vol.  I,  “Life”;  Vol.  II,  “Fire.” 
New  York:  Macmillan  Co.,  1917. 

Hamilton,  W.  H.  Current  Economic  Problems,  chap,  xi,  rev.  ed.  Chicago: 
University  of  Chicago  Press,  1919. 

Hudnut,  J.  M.  Studies  in  Practical  Life  Insurance.  New  York:  New  York 
Life  Insurance  Co.,  1911. 

Huebner,  S.  S.  Life  Insurance.  New  York:  D.  Appleton  &  Co.,  1915. 

- .  Property  Insurance ,  rev.  ed.  New  York:  D.  Appleton  &  Co., 

1922 

Riegel,  Robert,  and  Loman,  H.  J.  Insurance  Principles  and  Practices. 
New  York:  Prentice-Hall,  1921. 

Willard,  Charles  E.  The  A  B  C  of  Life  Insurance.  New  York:  Spectator 
Co.,  1917. 

Woodbury,  R.  M.  Social  Insurance,  an  Economic  Analysis.  New  York: 
Henry  Holt  &  Co.,  1917. 

Zartman,  L.  W.,  and  Price,  A.  A.  Yale  Readings  in  Insurance,  rev.  ed. 
Vol.  I,  “Personal  Insurance”;  Vol.  II,  “Property  Insurance.”  New 
Haven:  Yale  University  Press,  1920. 

chapter  xvin 

Emery,  H.  C.  “Speculation,”  in  Everyday  Ethics.  New  Haven:  Yale 
University  Press,  1910. 

Knight,  F.  H.  Risk,  Uncertainty,  and  Profit,  chaps,  xi,  xii. 


. 


* 


I 


INDEX 


Abandonment,  notice  of,  321-22 
Abstracter,  bonded,  332 
Accident,  industrial,  345-57 
Admiralty  bonds,  330-31 

Agricultural  production,  as  a  barometer 
of  business,  92-95 

Analysis  of  securities,  industrial,  190- 
200;  public  utility,  200-202;  rail¬ 
road,  200-202 

Annuities,  life,  259-62;  276-80 
Assumption  of  risk,  in  industrial  ac¬ 
cidents,  348 

Automatic  premium  loan,  264 
Automobile  insurance,  322-23 
Averaging  down,  160 

Babson  Compositplot,  103-6 
Bank  acceptance,  327-28 
Banking  barometers,  96-101 
Barometers  of  business,  86-101 
Barometric  data,  sources  of,  1 14-15 
Basis  contract,  in  future  trading,  206 
Blanket  policy,  in  fire  insurance,  298, 
300 

Bond  house,  see  Investment  bank 
Bonds,  investment,  187-88;  written  by 
surety  companies,  330-32 

Bond  tables,  error  in,  182-83 
Bradstreet’s  index  of  prices,  87 
Brookmire  barometers,  106-8 
Brokers,  stock  exchange,  relations  with 
customers,  131;  classes  of,  137-47 

Bucket  shop,  135 

Builders’  risk  policy,  in  marine  in¬ 
surance,  322 

Bureau  of  Labor  Statistics’  indices,  87 
Business  cycle,  phases  of,  63-71;  causes 
of,  71-83 

Business  failures,  as  a  business  bar¬ 
ometer,  90-91;  statistics  of,  117 

Business  forecasting,  chap,  on,  84-115 
Business  managers,  qualifications  of, 
43-45 

Business  problems,  analysis  of,  48-53 


Calendar  trading,  164,  218 
Call  loan  rate,  161-62 
Capitalist  lender,  risks  assumed  by, 
33-34 

Chicago  Board  of  Trade,  208-14 
Clearing  methods,  used  by  stock  ex¬ 
changes,  131;  by  boards  of  trade, 
211-12 

Coinsurance,  in  fire  underwriting,  299- 
301;  in  credit  insurance,  324 

Collision  insurance  (automobile),  323 

Combination,  reduction  of  risk  by,  19- 
21 

Commission  houses,  137-38 
Commission  rates,  on  stock  sales,  137-38 
Compensation,  reduction  of  risk  by,  26 
Composite  barometers,  101-14 
Conflagration  hazard,  290-91 
Consolidated  Stock  Exchange,  148 
Construction  and  the  fire  hazard,  290 

Constructive  total  loss,  in  marine  in¬ 
surance,  321 

Continuous  instalment,  in  life  in¬ 
surance,  259-62 

Contract  bonds,  331 
Contracting  out,  60-61 
Contributory  negligence,  in  industrial 
accidents,  348 
Control  and  risk,  364-66 
Convertible  term  policy,  243 
Co-operative  method  of  reducing  risk, 
18 

Cornering,  13 1 

Corporate  suretyship,  328-31 
Credit  insurance,  324-26 
Criminal  bail  bonds,  330 
Crisis,  68-71 
Crop  insurance,  323-24 
Curb  market,  130,  147-48 
Customs  and  internal  revenue  bonds, 
33i 

Dean  Schedule,  in  fire  insurance,  316, 
318 


397 


39? 


RISK  AND  RISK-BEARING 


Deferred  annuity,  279 

Depository  bonds,  331 

Depreciation  and  fire  loss,  289 

Depression,  business,  63-64 

Direct  settlement,  in  future  trading, 
210-n 

Disability  clause,  in  life  insurance 
policies,  243,  280-81 

Disbursement  of  life  insurance  funds, 
258-69 

Distribution  clause,  in  fire  insurance 
policies,  298 

Diversification,  202-5 


Employers’  liability  legislation,  348-49 
Endowment  life  policy,  243 

Ethics  of  gambling,  369-72;  of  in¬ 
surance,  373-74;  of  speculation, 


374-85 

Excess  profits  tax,  356-57 
Excess  floater,  in  fire  insurance,  298 
Expense,  in  life  insurance,  258-59 
Exposure,  and  the  fire  hazard,  290-cp 
Extended  insurance,  263-64 


Factory  mutuals,  305 
Fair  return,  357-60 
Farmers’  mutuals,  303-4 

Fellow-servant  doctrine,  in  industrial 
accident,  348 

Fidelity  bonds,  330 
Fiduciary  bonds,  330 

Fire  insurance,  chap,  on,  288-319; 
automobile,  323 

Fleet  insurance,  322 

Floating  policies,  in  fire  insurance,  298; 
in  marine  insurance,  322 

Fraternal  insurance,  272-76 
Friday,  David,  366-68 
Foreign  government  bonds,  188-89 
Futures  contract,  205 
Futures  markets,  207 


Gambling  enterprises,  125-26;  ethics 
of,  369-74 

General  policy,  in  fire  insurance,  298 

Government  bonds,  United  States,  187; 
foreign,  188-89 

Gross  premium,  in  life  insurance,  251 
Group  insurance,  269-71 
Guaranty  and  suretyship,  chap,  on, 
327-35 


Harvard  General  Index  of  Business 
Conditions ,  108-14 

Hazard,  fire,  288-91 

Hedging,  60;  chap,  on,  223-56;  375-78 

Idle  car  figures,  a  barometer  of  business, 
88 

Improvement  (a  phase  of  the  business 
cycle),  65-66 

Indemnity,  doctrine  of,  in  fire  insurance, 
292,  293 

Indices  of  general  business  conditions, 
see  Barometers  of  business 

Indorsement,  as  guaranty,  327-28 

Industrial  corporations,  reports,  88-90; 
securities,  190-91;  analysis  of  finan¬ 
cial  position,  194-200 

Industrial  insurance,  271-72 
Insurable  risks,  320 

Insurance,  field  of,  57-59;  speculative, 
59-60;  against  unemployment,  342- 
y  44;  against  business  losses,  366-68. 
^  See  also  Life,  Credit,  Fire,  Crop, 
Title,  and  Miscellaneous  Insurance. 

Interest  rates,  a  business  barometer, 
98-101;  adjustment  to  risk,  1 21;  and 
life  insurance,  250-57 

Inter-insurance^  see  Reciprocal  insur¬ 
ance 

Internal  revenue  bonds,  331 

Investment,  distinguished  from  specula¬ 
tion,  124-26.  See  also  Securities. 

Investment  banking,  152-55;  ethics  of, 
188 

Judgment,  business,  7-8;  45-55 
Judicial  bonds,  330 

Labor,  risks  of  33-34;  chap,  on,  336-54 

Land  speculation,  220-22;  384-85 

Large  numbers,  law  of,  19,  29-30 

Level  premium,  243-44 

Liability,  in  industrial  accidents,  347-48 

Liability  insurance,  automobile,  323 

License  bonds,  331 

Life  annuities,  243,  259-62,  276-79 

Life  insurance,  chap,  on,  237-87 

Limited  orders,  146,  157 

Limited  payment  life  insurance  policies, 

243 

Liquidation,  a  phase  of  the  business 
cycle,  68;  of  debts,  as  an  investment. 
117-18 


INDEX 


399 


Lloyd’s,  insurance,  59-60,  305-6 
Loading,  in  life  insurance,  251,  257-58 
Loans,  policy,  264-69 
Lost  security  bonds,  331 

Manipulation,  173-74 
Margins,  138,  209,  212 
Marine  insurance,  320-22 
Market  analysis,  12-15 
Market  orders,  146,  157 
Market  risks,  3-7 

Marketability  (of  securities),  185-86 

Miscellaneous  property  insurance,  chap, 
on, 320-26 

Monopoly,  as  a  source  of  profit,  42-43 
Monopoly  profits,  interference  with, 
357-59 

Monthly  income  policy,  279-80 
Moral  hazard,  291-92,  322,  323 
Mortality  charge,  in  life  insurance,  251 
Mortality  tables,  248-50 
Mortgage  clause,  in  fire  insurance,  298- 
99 

Municipal  bonds,  187-88 

Mutual  insurance,  life,  246-47;  fire, 
303-5;  tornado,  322 

Named  policy,  322 

Natural  premium,  244 

Net  premium,  251 

New  York  Cotton  Exchange,  214 

New  York  Stock  Exchange,  129-40 

Occupancy  and  the  fire  hazard,  290 
Occupation  boads,  331 
Odd-lot  dealer,  144-47 
Open  policy,  322 

Optional  settlements,  in  life  insurance, 
259-64 

Overinsurance,  291-92 
Over-the-counter  market,  150-51 
Owner-manager,  risks  assumed  by,  33- 
34 

Paid-up  insurance,  263-64 

Participating  policy,  244 

Permit  bonds,  331 

Personal  loans,  risk  in,  121-22 

Pig  iron,  a  barometer  of  business,  91-92 

Pit  scalping,  218 


Policy,  life  insurance,  241-45;  fire, 
295-98;  marine,  320-22;  title,  333-34 

Policy  loans,  264-69 
Premiums,  see  Rates 

Profit,  34-43;  insurance  of,  301-2; 
social  aspects  of,  385-91 

Profiteering,  362-63 

Prices,  as  barometers  of  business,  86-87; 
as  affected  by  speculation,  378-79 

Probabilities,  calculation  of,  27-31; 
classes  of,  45-46 

Produce  exchanges,  organization  and 
purposes,  205 

Property  damage  (automobile)  insur¬ 
ance,  323 

Prosperity,  67-68 

Protection  and  the  fire  hazard,  290 
Public  official  bonds,  330 

Public  utilities,  analysis  of  securities, 
201-2 

Pyramiding,  158-59 

Railways,  reports  of,  as  a  business 
barometer,  87-88;  securities,  anal¬ 
ysis  of,  200-202 

Rates,  in  life  insurance,  248-58;  fire, 
313-19;  marine,  322;  automobile, 
323;  compensation,  353-54 

Real  estate  titles,  insurance  of,  331-35 
Reciprocal  insurance,  306-13 

Recovery,  a  phase  of  the  business  cycle, 
65-66 

Rediscount  rate,  effect  on  expansion  of 
business,  99-100 

Renewable  term  policies,  243 
Rent  insurance,  301-2 
Reproduction  cost  and  fair  return, 
357-59 

Research,  reduction  of  risk  by,  11-15; 
limitations  of,  in  the  social  sciences, 
17-19 

Reserves,  reduction  of  risk  by,  21-26; 
in  life  insurance,  251 

Reversionary  annuity,  279 

Riders,  in  fire  insurance  contracts,  298 

Ring  settlement,  21 1 

Risk,  defined,  1;  sources  of,  2-5; 
methods  of  reducing,  11-36;  as¬ 
sumption  of,  33-34;  a  source  of 
profit,  40-41;  and  control,  43,  365- 
67;  transfer  to  specialists,  56;  adjust¬ 
ment  of  interest  rate  to,  121;  factor 
in  investment  policy,  181 


400 


RISK  AND  RISK-BEARING 


Risk-bearing,  specialization  in,  56,  119- 
21,  364;  and  the  social  order,  385-91 

Scalping,  158 

Schedule  rating,  in  fire  insurance,  315; 
in  compensation  insurance,  354 

Securities,  market  for,  128;  distribu¬ 
tion  of,  151-56;  analysis  of,  186-93; 
speculation  in,  381-84 

Short  sale  of  stocks,  138-40;  ethics  of, 

380- 81 

Single  premium  insurance,  243 
Socialist  state,  risk  in,  390-91 
Space  risk,  387-88 

Specialist,  on  stock  exchange,  143-44 

Specialization,  in  risk-bearing,  33-34, 
56,  1 19-21,  364;  of  capital,  a  source 
of  risk,  388 

Specific  policy,  in  fire  insurance,  298 

Speculation,  chaps,  on,  157-80,  205-22; 
inland,  220-22,  384-85;  in  securities, 

381- 84 

Spot  market,  226-27 
Spreading,  in  futures,  219 
Stock  clearing  corporation,  13 1 

Stock  companies,  in  life  insurance,  246- 
47;  in  fire,  302-3 

Stock  Exchange,  New  York,  129-40 
Stock  prices,  a  barometer  of  business, 
95-96 

Stop-loss  order,  146,  158-60 
Surplus,  in  life  insurance,  251 
Surrender  values,  in  life  insurance,  262- 
64 

Tailing  on,  218 
Tape,  ticker,  133 
Tax  exemption,  183,  187 


Technical  position,  161-63 

Term  insurance,  243 

Theft  insurance  (automobile),  323 

Three-quarter  value  clause,  in  fire  in¬ 
surance,  301 

Ticker,  132-33 

Time  and  motion  study,  15-17 

Time  policies,  322 

Time  risk,  122-24;  387-88 

Title  insurance,  332-34 

Tornado  insurance,  322 

Torrens  System,  334-35 

Transfer,  in  futures  markets,  211-12 

Transfer  of  risk,  methods,  32-33;  ex¬ 
amples,  56-61 

Two-dollar  brokers,  142-43 

Underwriting  of  security  issues,  328 

Unemployment,  of  productive  factors, 
24-26;  of  labor,  337-45;  insurance, 
342-44 

Universal  Mercantile  Schedule,  315-17 
Use  and  occupancy  insurance,  301-2 

Valued  policy,  in  fire  insurance,  293;  in 
marine  insurance,  321 

Voyage  policies,  322 

Wages,  and  the  risk  of  accident,  346-47 

Warehouse  bonds,  331 

War  risk  insurance,  281-86 

Wash  sales,  13 1,  174 

Weather  forecasting,  2 

Weather  map  reading,  218 

Whole  life  policy,  243 

Wire  houses,  142 

Workmen’s  compensation,  349-54 


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Two  cents  a  day  is  charged  for  each  book  kept 
overtime. 

If  you  cannot  find  what  you  want,  ask  the 
Librarian  who  will  be  glad  to  help  you. 

The  borrower  is  responsible  for  books  drawn 
on  his  card  and  for  all  fines  accruing  on  the  same. 

<§) 


